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S. HRG. 112–748 

COMPUTERIZED TRADING: WHAT SHOULD THE 

RULES OF THE ROAD BE? 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES, INSURANCE, AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

SECOND SESSION 

ON 

EXAMINING COMPUTERIZED TRADING 

SEPTEMBER 20, 2012 

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 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

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 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

RIKER VERMILYE, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT

JACK REED, Rhode Island, Chairman 

MIKE CRAPO, Idaho, Ranking Republican Member 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

TIM JOHNSON, South Dakota 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

KARA STEIN, Subcommittee Staff Director 

GREGG RICHARD, Republican Subcommittee Staff Director 

(II)

C O N T E N T S 

THURSDAY, SEPTEMBER 20, 2012 

Page 

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

Opening statements, comments, or prepared statements of: 

Senator Crapo ................................................................................................... 2 

WITNESSES 

David Lauer, Market Structure and High-Frequency Trading Consultant, Better Markets ........................................................................................................... 4 

Prepared statement .......................................................................................... 28 

Responses to written questions of: 

Senator Reed .............................................................................................. 72 

Senator Hagan ........................................................................................... 73 

Andrew Brooks, Head of U.S. Equity Trading, T. Rowe Price ............................. 5 

Prepared statement .......................................................................................... 40 

Chris Concannon, Partner and Executive Vice President, Virtu Financial, 

LLC ........................................................................................................................ 8 

Prepared statement .......................................................................................... 46 

Responses to written questions of: 

Senator Reed .............................................................................................. 76 

Senator Hagan ........................................................................................... 77 

Larry Tabb, Founder and Chief Executive Officer, TABB Group ........................ 10 

Prepared statement .......................................................................................... 49 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Statement of Senator Carl Levin ........................................................................... 80 

Statement of Micah Hauptman, Financial Campaign Coordinator, Public Citizen’s Congress Watch Division ........................................................................... 83 

Statement of Cameron Smith, President, Quantlab Financial, and Richard 

Gorelick, CEO, RGM Advisors ............................................................................ 94 

Summary and Excerpts from ‘‘High Frequency Trading and Price Discovery’’ 

by Terry Hendershott and Ryan Riordan .......................................................... 108 

(III)

(1) 

COMPUTERIZED TRADING: WHAT SHOULD 

THE RULES OF THE ROAD BE? 

THURSDAY, SEPTEMBER 20, 2012 

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

INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Subcommittee convened at 10:03 a.m., in room 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. I want to 

thank all of you for joining us today, especially our witnesses, and 

thank my colleague, Senator Crapo. 

As everyone in the room knows, computer trading has changed 

markets in fundamental ways, not the least of which is the speed 

at which trading now occurs. The benefits of automated trading for 

retail investors include access to real-time market data and being 

able to execute orders within a fraction of a second. The explicit 

costs of trading have also decreased. In one study that focused on 

pre- and post-decimal trading in the New York Stock Exchange 

listed stocks, average effective spreads decreased significantly for 

both small and large trades. The market is also more efficient, 

processing large volumes of data and more accurately setting market prices based on sometimes minute changes and market additions. 

However, since the May 6, 2010, Flash Crash, there have been 

a series of high-profile computer trading errors that highlight some 

of the dangers and costs of fast-moving computer-driven trading. In 

March, a computer glitch scuttled the initial public offering of one 

of the Nation’s largest electronic exchanges, the BATS Global Markets, Inc. In May, computer problems at the NASDAQ Stock Market plagued the initial public offering of Facebook stock. And last 

month, the Knight Capital Group, a brokerage firm at the center 

of the Nation’s stock market for almost a decade, nearly collapsed 

after it ran up more than $400 million of losses in minutes because 

of errant technology. 

Taken together, these failures in electronic trading appear to be 

affecting investor confidence in the U.S. market structure. Most of 

us consider American capital markets to be the best in the world. 

Our markets are known for their strength and resiliency, their 

openness and transparency, and their fairness to all market parVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
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ticipants. But our marketplace has been evolving very quickly and 

it is not clear that our rules have kept up. 

In particular, we need to focus on whether markets have the 

ability to avoid systematic failure triggered by a computer problem. 

Are our markets still fair? Is everyone playing by the same set of 

rules? And perhaps most importantly, are our markets still focused 

on long-term capital formation and the creation of jobs? 

Following the Knight Capital incident in early August, the SEC 

announced it would convene a roundtable of trading technologists 

in an effort to determine if brokers and exchanges are in control 

of their trading systems. SEC Chairwoman Mary Shapiro said she 

had asked staff to, quote, ‘‘accelerate ongoing efforts to propose a 

rule that would require trading venues to maintain the capacity 

and integrity of their systems,’’ and this roundtable is scheduled for 

October 2, 2012. 

Clearly, recent market events caused by technology-related 

issues have sharpened the debate on market infrastructure and the 

need to limit the broader impact of computer trading errors. However, in light of the enormous growth of high-frequency and algorithmic trading, there is a growing consensus that the entire regulatory scheme surrounding high-frequency trading firms and their 

algorithms should be assessed. 

Do current regulations reflect the impact of high-frequency algorithms on trading? Or can computer algorithms be programmed to 

operate properly in stressed market conditions? What challenges 

face firms when they are testing and implementing new systems? 

In addition, just last week, on September 14, the SEC settled 

first of its kind charges against the New York Stock Exchange for 

compliance failures that gave certain customers an improper head 

start on trading information. Computer issues, which include both 

disparities in the design of the New York Stock Exchange hardware systems and software problems, resulted in some customers 

receiving stock pricing trading data several seconds ahead of the 

general public. The SEC order marks the first ever SEC financial 

penalty against an exchange. 

The order and fine involving the New York Stock Exchange highlight another set of issues I hope we can discuss at today’s hearing. 

In effect, should the exchanges have control over the collection, aggregation, and distribution of market data? Should data be available to everyone at the same time, or should enriched data be provided more quickly to those who are willing to pay for it? 

We look forward to hearing your testimony on all of these topics. 

The capital markets are a public good, much like a highway. We 

need to have clear rules about the speed limits, who can use the 

HOV lanes. With our rapidly evolving capital market structure, we 

need to make it clear what the rules of the road are. 

Now, let me turn to my colleague, Senator Crapo, for his comments. Senator. 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Thank you, Mr. Chairman. 

More than half of all U.S. households, 57 million, according to 

one study, participate in our markets through either stocks or mutual funds, and the health and competitiveness of these markets 

3 

have an immediate and direct effect on our broader economy as 

well as on the wealth and prosperity of the American people. 

Over the last several decades, new forms of competition, technology, global growth in trading, and broader investor participation 

have integrated and interconnected the world’s capital markets and 

the financial services industry as never before. According to a 2010 

study by James Angle of Georgetown, Larry Harris of the University of Southern California, and Chester Spatt of Carnegie Mellon, 

technological innovations have led to major improvements in market quality. Their study found that execution speeds have increased, making it much easier for retail investors to monitor execution. In addition, retail commissions have significantly dropped 

and bid/ask spreads have narrowed. 

However, as Chairman Reed outlined, there have been too many 

technological failures in our market infrastructures since the Flash 

Crash of 2010. 

I thank Chairman Reed for holding this important hearing on a 

topic that has clearly captured the attention of academics, practitioners, and regulators. 

Yesterday, Georgetown University hosted a conference on financial market quality and the question of what is the empirical evidence on the role of alternative trading systems, algorithmic trading, high-frequency trading, dark pools, and new trading technology on market quality. In October, as has been indicated, the 

SEC will be holding a technological roundtable to discuss how to 

minimize trading errors and market malfunctions as well as how 

to respond to them in real time when they do occur. 

As we look at ways to help fortify our markets, especially during 

times of market stress, it is important that we examine all of the 

relevant empirical evidence in order to make informed policy decisions. I hope the witnesses at today’s hearing can provide some of 

that much needed evidence and I look forward to hearing their testimony. 

Thank you, Mr. Chairman. 

Chairman REED. Thank you very much, Senator Crapo. 

Let me now introduce our panel. I want to thank the panel for 

joining us today. We are extraordinarily lucky to have such qualified and insightful witnesses. 

Our first witness is Mr. David Lauer. Mr. Lauer is a Market 

Structure and High-Frequency Trading Consultant at Better Markets. He has helped financial service firms deploy high-performance 

trading infrastructure. He has also worked as a quantitative analyst and high-frequency trader himself. Thank you, Mr. Lauer. 

Mr. Larry Tabb is the founder and CEO of TABB Group. The financial markets research and strategic advisory firm focuses exclusively on capital markets. Founded in 2003, TABB Group analyzes 

financial market issues. Thank you, Mr. Tabb, for being here. 

Mr. Chris Concannon is currently a partner in Virtu Financial, 

where he serves as an Executive Vice President and is the Chief 

Compliance Officer at Virtu Financial BD. Prior to joining Virtu in 

2009, Mr. Concannon spent 6 years as Executive Vice President of 

the NASDAQ OMX Group. Thank you, Chris. 

Mr. Andrew Brooks is Vice President of T. Rowe Price Group and 

T. Rowe Price Associates. He has served as head of U.S. equity 

4 

trading for the firm since 1992. Thank you very much, Andy, for 

joining us today. 

We will begin with Mr. Lauer and then just go right down the 

panel. Please try to limit your testimony to 5 minutes. Your complete written testimony will be made part of the record, so feel 

free—in fact, I encourage you to summarize. Mr. Lauer. 

STATEMENT OF DAVID LAUER, MARKET STRUCTURE AND 

HIGH-FREQUENCY TRADING CONSULTANT, BETTER MARKETS 

Mr. LAUER. Good morning, Chairman Reed, Ranking Member 

Crapo, and Members of the Subcommittee. Thank you for the invitation to Better Markets to testify today, and thank you very much 

for holding this hearing on such a critical issue to our financial 

markets and our economy. 

Better Markets is a nonprofit, nonpartisan organization that promotes the public interest in financial markets. I will not take the 

time to go over all that we do today, but you can find it at 

bettermarkets.com. My name is David Lauer. As you indicated, I 

am a Market Structure and High-Frequency Trading Consultant to 

Better Markets. I also consult for IEX Group, a new private company that is developing an investor-focused equity market. 

Prior to consulting, I worked as a high-frequency researcher and 

trader at two of the largest HFT firms in the industry. And before 

that, I worked at a technology vendor that provided high-performance hardware to many high-speed trading desks on Wall Street. 

I would like to start with a story and tell you about my experience during the Flash Crash in May of 2010. The Flash Crash, as 

you know, caused the market to drop by a trillion dollars, nearly 

a trillion dollars, and then bounce back inexplicably within 20 minutes. I was on the trading floor that day as the market crashed and 

I witnessed something, quite frankly, unthinkable. The market 

simply disappeared. It was gone. We had no idea what was happening and we had no idea what would happen next. 

Our firm, like other HFT firms, immediately withdrew our liquidity from the market because we had no idea what was happening. We did not trust the information from our data feeds. And 

we had no obligation to remain in the market. More than half of 

the liquidity in the stock market was pulled in a matter of seconds 

and that dramatically worsened an already unstable situation. 

Anybody who seeks to minimize the role that HFT played in the 

Flash Crash either was not on a trading floor that day or is 

incentivized to maintain the status quo. 

Remarkably, since the Flash Crash, there have been no substantial changes in market structure. The U.S. equity markets are in 

dire straits. We are truly in a crisis right now. The past decade of 

technology revolution on Wall Street has been marked by two primary trends, extreme marketplace fragmentation and the rapid 

growth of HFT as the primary supplier of liquidity. Complexity is 

the hallmark of this market, whether from the fragmentation of 13 

exchanges and over 50 dark pools or the interaction between algorithms listening to high-frequency market data. While complex systems can often provide elegant solutions to intractable real world 

problems, they can also spin out of control at any moment and in 

completely unexpected ways. 

5 

There is no doubt that electronic trading has tremendous value 

to offer, enhancing the smooth functioning of the stock market and 

increasing competition, thus driving down the cost of trading. What 

we must be concerned with is whether the pendulum has swung 

too far and whether the nearly unregulated activity of 50 to 70 percent of the stock market should be allowed to continue unabated. 

A quick look at today’s markets reveal that stock market volatility has increased. Spreads have increased. Catastrophic event 

frequency has increased. IPOs have dramatically dropped. And retail investors are fleeing the stock market. 

As my written testimony demonstrates, the micro structure of 

the equity market has been altered by HFT and extreme market 

fragmentation, resulting in an excessively fragile market. This fragility is apparent in the impact that a single firm or even a single 

computer can have on the market at large, whether accidental or 

nefarious and predatory. 

I believe the market is so fragile because of structural inefficiencies, including the proliferation of the maker-taker business model 

and pay for order flow deals, the disappearance of affirmative market making obligations, the fragmentation of equity markets into 

lit and unlit venues with little regulation of the unlit venues, and 

the rubber stamp approval of exotic order types without proper 

study or justification. 

So what are we to do? Here are my suggestions, just a few of 

them, for rules of the road. I believe we need to unify trading rules 

regardless of lit or unlit venue, and the bar must be raised on offexchange execution standards. In order to receive a rebate from 

any venue, market makers must be registered and subject to affirmative market making obligations. A unique identifier should be 

assigned to every supervisory individual and attached to every 

quote. This would provide a contact person in emergencies and remove the cloak of anonymity that has allowed for manipulative behavior. We must eliminate pay for order flow practices. The SEC 

should pilot a 50-millisecond minimum quote time. And strong 

market technology standards are needed and regular audits to ensure they are being followed. 

In addition, I would like regulators to try a novel approach to 

surveillance and enforcement inspired by the Internet and open access and standards. Regulators could open up access to market 

data and incentivize independent programmers with prizes similar 

to how the X Prize functions, or percentage of fines like their whistleblower program, to help design better surveillance and enforcement tools for regulators. This can be part of advancing the SEC’s 

technology capabilities with a substantial investment in technology 

and personnel to bring the SEC into the 21st century. 

Thank you very much, and I am happy to answer any questions. 

Chairman REED. Thank you very much. 

Mr. Brooks, please. 

STATEMENT OF ANDREW BROOKS, HEAD OF U.S. EQUITY 

TRADING, T. ROWE PRICE 

Mr. BROOKS. Good morning, Chairman Reed, Ranking Member 

Crapo, and distinguished Members of the Senate Subcommittee on 

Securities, Insurance, and Investment. Thank you for the opporVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
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tunity to testify today on behalf of T. Rowe Price regarding the effects of recent significant changes in trading technology and practices on market stability. 

My name is Andy Brooks. I am a Vice President and Head of 

U.S. Equity Trading at T. Rowe Price Associates, Incorporated. I 

joined the firm in 1980 as an equity trader. I assumed my current 

role in 1992. This is my 33rd year on the T. Rowe Price trading 

desk. 

T. Rowe Price is celebrating its 75th year anniversary of advising 

clients. We are a Baltimore-based global advisor with over $540 billion in assets under management as of June 30, 2012, and more 

than three million client accounts. We serve both institutional and 

individual investors. We welcome the opportunity for discussion regarding the industry and market practices. 

Our firm is particularly focused on the interests of long-term investors. We appreciate the role other types of investors can have 

in creating a dynamic marketplace. However, as we talk with our 

clients, there is a growing distrust of the casino-like environment 

that the marketplace has developed over the past decade. We worry 

that the erosion of investor confidence can undermine our capital 

markets, which are so important to the economy, job growth, and 

global competitiveness. Reaffirming a strongly rooted commitment 

to fairness and stability in the market’s infrastructure is critically 

important. 

Over the past two decades, the markets have benefited from innovation and from new technology and competition. Generally, 

markets open on time, close on time, and trades settle. However, 

there are problems below the surface. Here are some of the things 

we find concerning. 

Order routing practices. We question the nature of various order 

routing practices. The maker-taker model, payment for order flow, 

and internalization of orders all seem to present a challenge to 

order routing protocols. Are order routing practices and incentives—are they an impediment to the over-reaching requirement to 

seek best execution on all trades? 

Colocation and market data arbitrage. We believe that the widespread use of colocation creates an uneven playing field that favors 

those who can and will pay for it. We question whether this has 

produced a market that values speed over fair access. In no other 

regulated industry is one party allowed a head start in exchange 

for payment. Our understanding is the current colocation practices 

allow for a market data arbitrage where some investors get 

quotations and trade data faster than others. This advantage is 

traded upon, causing some participants to believe they are victims 

of front running, or at the least, disadvantaged. 

Speed and impact on market integrity. Our sense is the almost 

myopic quest for speed has threatened the very market itself. It 

also seems to many that high-frequency trading strategies are designed to initiate an order to simply gauge the market’s reaction, 

then quickly react and transact faster than other investors can. 

This seems inherently wrong. Our understanding is that the continued push for speed is not producing any marginal benefit to investors and, in fact, may be detrimental. This pursuit of speed as 

7 

a priority is in direct conflict with the pursuit of market integrity 

as a priority. 

Inaccessible quotes and high cancellation rates. The growth of 

HFT has led to increased volume. However, whether the corresponding volume is good or bad deserves analysis. Volume does 

not necessarily mean liquidity for large institutional investors. 

When you combine high HFT volumes and even higher cancellation 

rates, these forces can combine to undermine market integrity and 

cause deterioration in the quality and depth of the order book. We 

feel that this volume is transitory and misleading. 

Challenges to the national market system. We believe the original construct of Regulation NMS was laudable and designed to encourage competition. However, we do not believe this regulation 

contemplated today’s highly fragmented marketplace, where we 

have 13 different exchanges and over 50 unregulated dark pools. In 

such a fragmented market, can one really be confident that achieving best execution, given the explosion of market data traffic? We 

question the market’s ability to process the overload of market 

data. 

Conflicts of interest. We question whether the functional roles of 

an exchange and a broker-dealer have become blurred over the 

years and could warrant regulatory guidance regarding the inherent conflicts of interest. It seems clear that since exchanges have 

migrated to for-profit entities, a conflict has arisen between seeking 

volume to grow revenues and their obligation to assure an orderly 

marketplace for all investors. 

HFT trading strategies. Professional proprietary traders often 

have divergent interests from those investors concerned about the 

long term. Whether the average holding period for such traders is 

measured in seconds as opposed to months or years, we have destabilized the market. Given recent market volatility, more study is 

warranted to assess the impact of the exponential growth of shortterm trading strategies. Most rules and regulations seem to further 

enable those with short-term profit incentives, as evidenced by the 

proliferation of new order types suggested by exchanges and approved by regulators. 

Suggestions. We believe it is time to step back and examine the 

market structure and how it impacts all investors. A good first step 

might be to experiment with a number of pilot programs to examine different structural and rule modifications. We suggest a look 

at the appropriateness of colocation as a general practice and enhanced oversight of high-frequency trading and other strategies 

that might be unduly burdensome to overall market functionality. 

We would like to see a pilot program where all payments for order 

flow, maker-taker fees, and other inducements for order flow routing are eliminated. We envision a pilot where there are wider minimum spreads and mandated times for quotes to be displayed to 

render them truly accessible. These programs can include a spectrum of stocks across market caps and average trading volumes, 

among other factors. We also suggest a pilot program of imposing 

cancellation fees for unacceptable trade-to-cancellation ratios. 

A key question is, should we foster consolidation in this fragmented market? At a minimum, should we raise the barrier for beVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
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coming an exchange? In our opinion, requiring a more robust testing for new software would seem to make sense. 

In conclusion, T. Rowe Price Associates appreciates all the efforts 

of the SEC and Congress as we strive to make the markets better 

and fairer for all participants. The consolidated audit trail, large 

trader ID, limit up-down initiatives are all improvements. We suggest any regulatory proposals be aligned with the goal of making 

the markets simpler, more transparent, and less focused on speed. 

We applaud the Committee’s interest in making sure the right 

questions are asked. There are currently over 1,000 order types to 

express your buy and sell interest and we suggest that a simplified 

model may be more efficient for all investors. 

The issues we face are enormously complex and we certainly do 

not have all the answers. We believe it is time to revisit the historic responsibility to provide a fair and orderly market. Thank 

you. 

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

Mr. Concannon, please. 

STATEMENT OF CHRIS CONCANNON, PARTNER AND 

EXECUTIVE VICE PRESIDENT, VIRTU FINANCIAL, LLC 

Mr. CONCANNON. Chairman Reed, Ranking Member Crapo, Members of the Subcommittee, I want to thank you for the opportunity 

to appear before you today. My name is Chris Concannon and I am 

the Executive Vice President of Virtu Financial. 

Virtu Financial is a global electronic market maker. We are a 

market maker on over 100 markets around the globe. We make 

markets from our offices in New York, L.A., London, Dublin, Singapore, and Sydney. The company’s market making activity spans 

across multiple asset classes, including cash equities, fixed income, 

currencies, futures, options, energy products, metals, and other 

commodities. 

Virtu operates as a registered broker-dealer in the U.S., as a registered investment firm in Europe and in Asia. We are also a market maker on the NYSE, the NASDAQ Stock Market, the BATS 

Exchange, NYSE Arca, and NYSE Markets. And in Europe, we are 

a market maker on the London Stock Exchange, the Swiss Stock 

Exchange, Euronext, and Deutsche Bourse. 

In discussing the state of the U.S. equity market, I start from the 

premise that our equity markets are the most dynamic and the 

most efficient markets in the world. My firm trades across all 

major financial markets and no market can compare to the U.S. equity market in terms of pricing efficiency and liquidity. Over the 

last 4 years, I have witnessed an unprecedented number of claims 

that our markets are horribly broken, unfair, and dangerous. These 

claims tend to be short on facts and evidence, but long on press 

coverage and book deals. 

Let me be clear. Our markets are not perfect. It has flaws and 

unnecessary complexity. The U.S. equity markets is overly fragmented and likely over-engineered. Stocks in the U.S. trade electronically on 13 national securities exchanges and over 50 dark 

pools. If we had a blank canvas and we were able to redraw our 

entire market structure, it would never look like the model that we 

use today. 

9 

I would like to focus on three areas that I believe deserve further 

review: First, our choice of a single market structure for all listed 

securities; second, our market’s failure to enhance market maker 

obligations; and finally, the industry’s current risk management 

standards. 

First, our market is currently designed as a one-size-fits-all. 

What I mean by that is that most of our major market structure 

rules do not distinguish between the size, the market capitalization 

of the listed company, or the trading characteristics of their stock. 

Our markets are designed to execute all stocks, regardless of shape 

or size, using the same market mechanism. A stock that trades 

once per day is traded in the same market structure as a stock that 

trades one million times per day. It is like we are putting a bicycle 

on the fast lane on a highway and wishing it luck. I believe we 

should revisit our current market structure in order to create a better pricing mechanism for all stocks of different shapes and sizes. 

My second area of focus is our market’s failure to enhance market maker obligations. While my firm is a market maker and it is 

easier for me to call for enhanced market maker obligations, I fundamentally believe that we need to increase obligated liquidity in 

our markets. Flash crashes, miniflash crashes, and other market 

disruptions demonstrate the need for additional obligated liquidity 

in our market. However, I believe enhanced market maker obligations should be targeted where they are most needed, and that is 

in the less liquid stocks. 

My final area of focus is the industry’s current risk management 

standards. In light of recent events, I believe that the industry 

should explore ways to improve its risk management standards. 

First, pretrade risk management limits are already required by the 

Securities and Exchange Commission under the market access 

rule. Under that rule, which has been in effect for over a year, 

firms are required to establish pretrade credit limits for every customer account, and more importantly, for the firm’s own proprietary account. These credit limits are a firm’s primary defense 

against unwanted trading activity by the firm or its clients. 

Second, the industry is currently exploring specialized kill 

switches that would be administered by the exchanges. These kill 

switches would be a systematic shut-off of a firm if it exceeded prescribed or preset trading limits. Kill switches would not be a primary defense but rather a secondary defense to backstop the failure of other risk management measures operated by the firm. Kill 

switches have operated effectively in the futures exchanges for 

many years. Such a kill switch would have severely limited the 

damage done on August 1. 

The third component to enhanced risk management is one of the 

most important, I believe. A simple feature referred to in the industry as drop copies should be required as a risk management tool. 

Drop copies are separate and distinct connections offered by exchanges and other markets. Drop copies, which are widely used by 

the industry, provide a real time echo or copy of a firm’s trading 

activity on a given exchange. 

A good example of how drop copies work is if you are on Amazon 

or iTunes and you click that ‘‘purchase’’ button, you get a confirm 

that pops up in your window. At the same time, an email is sent 

10 

to you. That is exactly how a drop copy works in our industry, and 

these drop copy emails are actually very helpful. I recently had my 

12-year-old daughter—she actually became a rogue trader on 

iTunes. So luckily, the drop copy emails informed me that she was 

a rogue trader and I put in a kill switch. 

[Laughter.] 

Mr. CONCANNON. While I believe firms should have a robust 

process for developing and testing new software, the industry must 

have advanced risk management systems to limit the risk of unintended trading activity by a firm or by its clients. We know with 

certainty that software has bugs, hardware crashes, and networks 

go down. The industry must build risk protections that assume the 

worst while a robust development and testing process avoids the 

worst. Pretrade risk checks, kill switches, and real time drop copies 

protect us from the worst events. 

Thank you again for the opportunity to be here. I would be 

happy to take questions. 

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

Mr. Tabb, please. 

STATEMENT OF LARRY TABB, FOUNDER AND CHIEF 

EXECUTIVE OFFICER, TABB GROUP 

Mr. TABB. Good morning, and thank you, Chairman Reed, Ranking Member Crapo, distinguished Senators. I am Larry Tabb, 

founder and CEO of the TABB Group, a financial markets research 

firm. We provide research and advisory services to financial markets firms regarding how the markets operate and how investors 

perceive the markets and the brokers who serve them. I am also 

a member of the CFTC High-Frequency Trading Committee. I 

would like to thank the Committee for this opportunity to present 

my views on computerized trading and equity market structure. 

Unfortunately, the structure of the U.S. equity markets has come 

under scrutiny, from high-frequency trading, to the Flash Crash, to 

Facebook and BATS IPO challenges, to the latest Knight Capital 

Group technology issue. Market professionals as well as the general public are concerned that the U.S. equities markets are not 

functioning effectively. 

I have submitted a 20-page paper answering the six questions 

that the Committee has defined to that end. I will only summarize 

my answer to question six. What, if any, policy changes should be 

considered by regulators, Congress, in order to better protect investors, maintain fair, orderly, and efficient markets, and facilitate 

capital formation? 

My first statement is do no harm. The U.S. markets are the 

deepest and most liquid on the globe. The markets are also complex 

and interrelated. Small changes can cause significant impact. So, 

first, do nothing radical. A radical shift of market structure will unquestionably hurt investors. Radical changes provide incentives to 

traders to analyze rule changes and profit off of them. This will 

only cease once investors pressure brokers and brokers develop better countermeasures. It can take years to restore this equilibrium. 

To that extent, what I would do, first, defragment the market. 

While we do not want to limit competition too much, 13 equities 

exchanges, 50 or so ATSs, and who knows how many internalizing 

11 

brokers is too many. Stop granting new exchanges and ATS licenses immediately. Determine the optimal number of exchanges, 

ATSs, and internalizing brokers, and as these entities go bankrupt, 

merge or consolidate exiting firms and reduce the number of licenses. 

Second, better manage broker ATS solicitations. An order for 

50,000 shares can easily be executed in 200 trades across various 

venues. Understanding what happens to this information is very, 

very difficult. While institutions typically receive execution information, it is more difficult to tell where these orders were routed 

and not executed. Where these orders were not executed leaks information into the market. Between brokers soliciting the other 

side, ATSs routing to each other, and exchanges routing to ATSs, 

virtually all professionals that have wanted to trade against this 

order have seen it before it is displayed to the public. 

Third, better manage MPVs, minimum price variations. Currently, we have a minimum 1-cent MPV for all stocks over a dollar. 

I would follow the direction of the JOBS Act in implementing a test 

program to widen spreads for less liquid and smaller capitalized 

stocks. 

Fourth, greater transparency of order types and routing mechanisms. Currently, most exchanges post their order types. However, 

these descriptions are not intuitive. Exchanges, ATSs, ECNs, 

internalizers, and even brokers need to begin to provide greater 

transparency, descriptions, and concrete examples how each order 

type works, how fees and rebates are generated, where in the order 

book orders show up, how and when orders are routed, and how 

these orders change under various market conditions. 

Five, develop a market-wide consolidated audit trail for equities, 

futures, and options. Develop incentives that will facilitate the cooperation of the SEC, CFTC, and various SROs to ensure harmonious oversight. Develop clear rules on what manipulative behavior 

is in electronic markets. Provide regulators the tools and people 

who can understand the market, find the people and/or machines 

that are driving manipulative behavior, and give the regulators the 

power to stop, fine, and jail manipulators. If we had confidence 

that our regulators were able to effectively police the market, it 

would give the public more confidence that pernicious behavior was 

being flagged, challenged, and resolved. It would provide investors 

with the assurance that our markets are safe again for trading, investing, and raising capital. 

I would like to thank the Committee for allowing me to present 

TABB Group research and my personal thoughts on how to fix the 

U.S. equities market structure. If there are questions, I would 

enjoy answering them at this time. 

Chairman REED. Thank you all very much for excellent testimony. I think what you have made very clear is this is a complex 

issue, that you have raised extraordinarily important questions. It 

is going to take us a while, I think, to come to the answers, but 

this is the first step. In fact, in collaboration with my colleague, I 

would assume we would entertain other hearings in this regard because this issue is not a one-stop and quick fix and move on. 

But in that spirit, one of the issues—I was particularly struck by 

Mr. Brooks’ comments about the issue of speed in conflict with 

12 

market integrity. And this issue has been raised in many different 

venues, even by people back home in Rhode Island. Are these markets just too fast now? Are we losing something bigger? And let me 

pose this to all the panelists, your thoughts briefly on that. We will 

do a 7-minute first round and then we will come back for a second 

round and more, and we have the luxury of asking some questions. 

So this whole issue of speed. Are things too fast, and if that is 

the case, how do you slow it down? Mr. Lauer, do you want to comment first, and then Mr. Brooks, and Mr. Concannon. 

Mr. LAUER. I would love to. Thank you, Senator. I think that the 

issue of speed is a critical one, absolutely. And the idea of slowing 

things down is difficult. These are, as you said, complex issues. I 

think that speed for speed’s sake is now being well proven to create 

very little social welfare and utility. 

There is an interesting study that came out on the externalities 

of high-frequency trading and they examined two consecutive technology shocks which increased—or decreased latency from microseconds to nanoseconds. And while they found that it dramatically 

increased trading speed and the cancellation ratio, there was no 

impact on trading volume, spread, depth, or pricing efficiency. So 

I think we have found a limit to the benefits of speed, and this is 

well supported empirically. 

There are some ideas around. One of those is a minimum quote 

life, as I mentioned in my oral testimony and my written testimony, as Mr. Brooks has, as well. I think that that is an interesting first step and I think it is worth a pilot program. I completely agree with Mr. Brooks that we need to be trying new ideas 

out. We need to be going through some pilot programs and finding 

out what the impact of these things would be, because we can simply surmise on what the impact of a 50-millisecond quote life would 

be, but we do not really have a perfect sense. 

That same study found that between 30 to 40 percent of market 

data was—are quotes that were put into the market and canceled 

within 50 milliseconds without being traded on, and the cancellation rates on quotes that are out there for less than 50 milliseconds 

is, I believe, over 96 percent. So I do believe that is one area that 

we can look at. 

Chairman REED. Mr. Brooks, and then I am going to make sure 

everyone has a chance to answer this question. 

Mr. BROOKS. Thank you. I think our sense and what we hear 

from our clients is really that the marginal return for investors is 

perhaps negative with the increasing speed. So it begs the question, why do we need to be faster? Who benefits from that? And I 

think our question and our concern is, who is the speed for? We 

do not think it is for investors. So that means someone else is interested in speed and maybe their interest is not as genuine, if you 

will, when you think about who are the markets supposed to serve. 

So it is a very complex issue. I appreciate the Chairman acknowledging that as we work together to find solutions. But there is a 

concept that speed kills on the highway. You referenced the highway analogy. So I think speed causes us great anxiety. 

Chairman REED. Mr. Concannon, please. 

Mr. CONCANNON. Thank you. I think speed is—and I agree with 

the panelists that it is one of the more difficult issues to address, 

13 

because if you do conclude that we need to regulate speed, we then 

are left with the question, at what speed should we all move at? 

And we then may move to the slowest common denominator in 

terms of speed. Speed and the ability to post a quote and cancel 

a quote, they all, in turn, are frictions in the market. And we have 

reduced frictions to the most extreme levels to create what is the 

most efficient market around the planet. 

We see today—we do not need a pilot—we see markets that we 

trade in that have minimum quote life, and the impact is spread. 

If you are posting a quote in the market as a market maker, you 

are taking risk. You are posting actually an option to the market, 

a free option for them to execute against you when the intrinsic 

value of that asset changes. That free option will be adjusted based 

on the life of that option, which ultimately is the minimum quote 

life. And so there is an actual impact to our market structure when 

we slow down the market. 

Do I think we have reached an equilibrium in speed? Yes. I do 

not think moving mics—one or two mics further—is adding any 

value to the investing public. But of more concern is slowing down 

the market to some common denominator. 

Chairman REED. Thank you. 

Mr. Tabb, please. 

Mr. TABB. My issue, my concern, is that—I agree with the panel 

that we have gotten faster than we can probably handle. The challenge is, how do you actually stop it, and what happens if you stop 

it? 

So the first issue would be, is, OK, so I have a 50 millisecond 

or even microsecond minimum quote life. What happens and who 

manages that? So if I am a trader and I have a minimum quote 

life, am I constantly pinging the exchange to take me out, take me 

out, take me out, and they say, no, no, no, no, no, and I say, take 

me out, take me out, take me out, and they say, no, no, no, no, and 

finally 50 microseconds happens and then all of a sudden we have 

created all this extraneous traffic that bogs down the rest of the 

market, just all these messages to get me out and how is that managed. 

The second issue becomes, is we constantly have folks like, you 

know, Intel and IBM and Cisco and networking companies speeding up the clocks like with chips. Do we just say, OK, you cannot 

use the best computers anymore, and how do you manage that and 

who governs? Do we go to, like, a stock car race where everybody 

needs to trade out of the same computer, and how does that work 

and operate? 

And then once you get two or three levels behind, you know, behind actually operating specifically on the exchange, do I actually 

know what my customers are doing or their customers are doing 

and how do I manage that, as well? 

So there are a lot—yes, we have kind of gotten to the point 

where the market is too fast, but to a certain extent, maybe the 

answer is that the folks like Andrew need to actually complain to 

their brokers to have them do a better job of managing the execution of their orders. And if they do not like the execution, fire their 

broker. 

14 

Chairman REED. I am going to yield to Senator Crapo, but I have 

another series of questions, because I think there are some major 

issues here that the whole panel ought to address and I would like 

the comments. Just to sort of preview, one is the issue of fragmentation, the issue of market maker obligations, and there are 

probably a couple of others. And Mike, if you want to get into 

them, be my guest, but Senator Crapo, please. 

Senator CRAPO. Thank you very much, Mr. Chairman. 

I have a question, first, for Mr. Concannon. What kind of a system does your company have in place to avoid erroneous events? 

Mr. CONCANNON. Thank you. Well, we have a number of systems 

in place, what we call filters, and filters will trigger a lockdown to 

our trading system. So if we place an order that the filter determines is out of range from the price of the market, it will stop that 

order from entering the market and it will shut down the actual 

trading strategy, and that works all day long, and it has been in 

existence for many years. It is actually a component of the SEC’s 

market access rule, so it is now technically required to have in 

place. Every time you send an order, whether it is for your own account or your client’s account, you have to filter for an erroneous 

order entering the market. 

Senator CRAPO. So this is basically an industry standard at this 

point? 

Mr. CONCANNON. Absolutely. It is an industry standard. 

Senator CRAPO. My next question is—I would like you to answer, 

Mr. Concannon, but also, I would like to have the entire panel 

weigh in on this, if you would. Yesterday, there was a Wall Street 

Journal article about order types called slide and hide. The article 

suggested this order type allows high-speed firms to trade ahead of 

less sophisticated investors, potentially disadvantaging them and 

violating regulatory rules. What is your perspective on this? 

Mr. CONCANNON. That is a great question. First of all, our firm 

does not generally allow exchanges to slide our orders. I do not 

know if you have noticed, but—— 

Senator CRAPO. How does this work? 

Mr. CONCANNON. Sure. The way it would work would be you 

would place an order that locks the market, and what that means 

is it is an order that would otherwise execute against a quote in 

the market and that order would be restricted from being posted 

and locked. So the order type, the slide order type, would slide your 

order back to what is a compliant price and post it at that price. 

The problem with that order type is it is not permitted for any 

broker to take an investor’s order and slide it. So it is not actually 

an investor-used order. So there is no broker that says, I have an 

order that is marketable, because it will lock the market, and I am 

going to have an exchange slide it back to a different price. That 

is a violation of Best X and they cannot use it that way. So that 

order type—they would actually have to, because it is a marketable 

order, they would have to execute it, or execute it against the quote 

in the market. 

That order type is mainly used for professional traders. So the 

issue is, does that slide order used by a professional trader, have 

they read the rules that the exchange filed with the SEC that were 

published and did they understand the order type that they were 

15 

using? It is not that investors, retail investors or even Mr. Brooks’ 

firm using that order and being disadvantaged. His broker cannot 

use that order and slide his orders when they would otherwise execute at the market price. So it is really an issue of professional 

trader versus professional trader, trying to understand how the 

order types work. 

Senator CRAPO. Mr. Lauer. 

Mr. LAUER. Yes. Thank you, Senator Crapo, if I may. I think that 

hide, not slide, and many other order types are great examples of 

complexity in the marketplace, and at times, not necessarily complexity for complexity’s sake but perhaps unjustified complexity. I 

think that the bar for approving new order types needs to be revisited, and I think that it would be a great service to reinstilling 

some confidence in the marketplace if it was easier for the average 

person to get their head around what these order types mean. 

And the fact that we need so much explanation for just this one 

order type, let alone—I mean, there are, as Mr. Brooks said, a 

thousand order types if you take individual ones at each market 

center. There are so many order types that it just—it is something 

that people who are not in the business have a very difficult time 

with and there is absolutely no reason they should not have a difficult time with that. 

Normally, the bar for regulating and passing rules is very high. 

It demands a lot of study and justification as to the utility of a new 

rule or regulation, and I think that that same standard should be 

applied to all of these exotic order types. And there should be, at 

this point, a great amount of evidence as to the utility of these 

order types because they have been around for a while now. I think 

that that would be an interesting exercise to go through. 

Senator CRAPO. Mr. Brooks or Mr. Tabb, do either of you want 

to weigh in? 

Mr. BROOKS. Thank you. I think the only thing we might suggest 

is that we might refer to the point Mr. Lauer made, and that is 

it really has added complexity to the marketplace and we are wondering why. Why is someone trying to make things more complex? 

And at the Georgetown conference yesterday that you all referenced, there was some discussion about whether it would make 

sense to have a moratorium on approval of new order types until 

the marketplace can really come together and get their arms 

around, what are we doing here? Why do we need so many ways 

to express trading interest? And is there something else going on? 

So it is a question that is troubling and we are not sure what the 

answers are. 

Senator CRAPO. Mr. Tabb. 

Mr. TABB. I do not disagree. I think that—and in my written testimony, or my oral testimony, I presented, I think, that we need 

much more transparency on these order types. Should the SEC be 

looking over these in more detail? I think, yes. I think that many 

of the order types that are out there are not well known, even to 

professional investors. And I think that greater transparency and 

reducing the number would probably be a good thing. 

Senator CRAPO. Yes, Mr. Concannon. 

Mr. CONCANNON. On the topic of order types, I mean, I do agree 

that we have way too many order types, but before Reg NMS, beVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
16 

fore that rule was installed in our marketplace, we had very few 

order types. We had market orders and limit orders. It was with 

the complexity of Reg NMS that interconnected all of our markets 

and gave us 50 dark pools that we ended up with all these order 

types. 

And I do have to disagree. I heard—I read in testimony of a rubber stamp approval at the SEC. I personally filed order types. 

There was no rubber stamp approval. It would take 6 months or 

longer to get these order types approved, and people like Robert 

Cook and David Shulman and Bob Colby are far from rubber 

stamping order types and they have never rubber stamped order 

types. So it is a difficult process to get these things approved. They 

are analyzed. There are far too many. But those order types all 

came because of Reg NMS. 

Senator CRAPO. Thank you. 

Chairman REED. Well, thank you, Senator Crapo, and again, the 

questions are, I think, right on target and the answers are not only 

interesting, but provoke further questions. 

Let me take up some of the issues that were suggestive of some 

additional testimony. I go back to the issue of fragmentation, of 

which you all commented upon, and just give you an opportunity 

to add anything further that you might want to say with respect 

to the issue of the fragmentation. 

One of the ironies is that the national markets were put in place 

because there was an oligopoly operating, and now we have—have 

we created—sort of gone too far in the other direction. I think, Mr. 

Tabb, you could begin. 

Mr. TABB. I think we have gone too far. I think that while it does 

not sound like a bad thing to fragment the markets and have multiple places to trade and have competition, every time a message 

pings off a market, a dark pool, an internalizer, it releases information. And so with trying to find the other side of the trade, information is bouncing all over the place that investors do not really even 

know that is occurring. And I think, to a certain extent, it disenfranchises the investor and leaks information. 

That said, on the other side, there are organizations who spend 

a lot of time, money, and effort building up their liquidity pools and 

their businesses. You cannot really just say, OK, tomorrow, they do 

not exist. I am not sure eminent domain would be a great idea. 

So the question then becomes is how do you defragment them 

and how do you do it in a fair way, and I do not know the answer 

to that, but I think we clearly have too many places to trade. 

Chairman REED. Mr. Concannon. 

Mr. CONCANNON. Well, when we take a look at our market and 

we see 13 exchanges, 50 dark pools, you have to understand that 

in every stock, there is a bid or an offer finding its way in one of 

those liquidity zones. And what that does is it thins out our overall 

liquidity. So on a normal day, it works. On a day of high volatility, 

like May 6, that thin layer of liquidity is easily pierced. When it 

is not consolidated in one place, you can pierce through that liquidity and you have the volatility that we saw that day. So fragmentation has caused increased volatility, but I agree with Larry. It is 

very difficult to consolidate that market. Again, on an average day, 

there are dealers that are professionals that try and consolidate 

17 

that market and it is a very liquid market despite the fragmentation. It is really those days that we have shocks and events. 

Chairman REED. Mr. Brooks, do you have any comments? Mr. 

Lauer? Mr. Brooks. 

Mr. BROOKS. Senator, if I might, I do not think we know the answer in terms of what the perfect number of exchanges or dark 

pools might be, but we do wonder and hear others question whether the system, with all these different venues, can process the data 

that is being generated. I mean, there is just an enormous amount 

of data, and some of that data gums up the system and slows it 

down and that is troubling. 

And, two, to pick up on Mr. Concannon’s point, it is awfully hard 

to figure out the supply demand equation in the stock today when 

there are so many different places that trading interests reside. So 

if you are trying to find out if there is more to buy or more to sell, 

good luck. It is tough today. 

Chairman REED. Mr. Lauer, a comment, and then I have another 

question. 

Mr. LAUER. Yes. I think that what we have seen with this massive fragmentation and internalization and dark pools, as Mr. 

Concannon alluded to, is what is called adverse selection. As order 

flow goes from place to place, from retail institutional investors, before it makes itself—before it gets to the lit exchange, it is picked 

off at every step of the way by internalizers, by dark pools, by highfrequency traders, proprietary trading desks. And, therefore, the 

flow that eventually gets to the lit exchanges is what we refer to 

in the industry as toxic flow that nobody wants to trade with. And 

what we have done is we have reduced the number of natural buyers and sellers in the market, as Mr. Concannon said when he was 

just answering. So I think that that has been one of the dramatic 

effects of fragmentation, internalization and dark pools. 

There was a study out of Rutgers that demonstrated that because of all the off-exchange executions, spreads are widening in lit 

exchanges by an average of 1.28 cents on the New York Stock Exchange, and that is a dramatic effect and it is a direct result of this 

adverse selection because it becomes harder to be a profitable market maker in such a scenario. 

I think that we can take a cue from other countries in this regard and we can raise off-exchange execution standards. We can 

say that you must meaningfully price improve in order to internalize, and meaningful price improvement does not mean a tenth 

of a cent. In Canada, they have one standard that says at least a 

tick size, a minimum tick size, and if the spread is one penny, then 

at least half a tick size. They also have a minimum order size. So 

if you are going to internalize or execute on a dark pool, it has to 

be an especially large order. That is why you have dark pools and 

that should be the reasoning behind that. 

I also think that eliminating pay for order flow is an important 

step in order to combat this adverse selection problem. 

Chairman REED. Thank you. Let me raise another topic, and that 

is this issue of market making. Mr. Concannon, your firm is a market maker in several different venues. And related to this, and it 

might not be precisely related, is another issue that we hear about 

and was referred to in the testimony is people coming into markets, 

18 

making a bid and then canceling it within fractions of a second, 

sort of probing, which creates more information but is not the traditional, what people think what markets are, where someone really wants to buy something and they are looking for the best price 

and when they get it, they are going to close the deal. 

So this whole issue of market making obligations on everyone, 

which I think you raised in your testimony, can you comment upon 

it? Then I will ask Mr. Tabb and then everyone else who wants to 

make a comment. Please. 

Mr. CONCANNON. Sure. I think if we go back 20 years and we 

look at our market makers, they had fairly strict obligations, people like specialists on the floor, but they had exceptional benefits. 

They had exclusive rights to the market and the incoming order, 

and that was worse than the benefits that they provided as market 

makers. So we made a decision and we changed our markets to be 

an all to all. 

And I do believe in some products that all to all model, where 

anyone can be a market maker or market maker obligations are 

light, at best, we lose a little bit in terms of liquidity. And so there 

are stocks that I do not necessarily think they need obligations and 

market makers all day long, every minute of the day, but the good 

majority of our market really needs to be supported by market 

makers with real obligations to be at the best bid or offer. 

The most important thing for me in terms of market maker obligations that do not exist is that not only should you be at the best 

price, but you should be at the next best price and one more price 

below that. You need to provide—a real market maker makes 

depth of liquidity markets, not just a thin layer at the best bidder 

offer. 

Chairman REED. Mr. Tabb, your comments. 

Mr. TABB. I agree. I think that we should have some sort of market maker obligations. Now, that said, market maker obligations is 

not a panacea. If we wind up having some sort of crash, people will 

not step in front of a train, catch a falling knife, whatever analogy 

you want to make. They are not going to go out of business because 

they have an obligation. But that said, in the general market or 

general interday volatility, I believe we should have stronger market making obligations. 

Chairman REED. Thank you. Comments, Mr. Brooks, Mr. Lauer? 

Mr. Lauer. 

Mr. LAUER. Yes. Thank you, Senator. I believe that—I completely 

agree with Mr. Concannon and I think that market making obligations should be the cornerstone of any new efforts. And I believe 

strongly that they should be tied to receiving a rebate on any 

venue in which securities are transacted, be they an exchange, 

ATS, ECN, dark pool. Any place that somebody can receive a rebate, that rebate should be tied to an obligation to make markets. 

And as I explained in my written testimony, one of the better 

studied and more beneficial models is what is called the maximum 

spread model. I think the way obligations have been done in the 

past is normally something like a 90 percent of the time you need 

to be in the market. There are other models, but that is a standard 

one, and both Mr. Concannon and Mr. Tabb are correct that that 

would not address the issues of a crash or a flash crash, which is 

19 

why I think we need to examine much more stringent market making obligations. And some studies have developed some models for 

that that do demonstrate they would prevent flash crashes and 

that the market makers in some instances would have to be compensated for their losses. But the overall improvement in social 

welfare far outweighs the cost to that compensation. 

Chairman REED. Mr. Brooks, you have a comment, and then I 

will yield. 

Mr. BROOKS. I do. Thank you. I guess our thought would be that 

if you are going to receive a benefit as a market maker, you have 

to provide one, as well. 

Chairman REED. Thank you. 

Senator Crapo. 

Senator CRAPO. Thank you, Mr. Chairman. 

As I listen to the different issues being raised here and the potential solutions, a question occurs to me. This is a broad question 

and I would like to ask each of you to just weigh in on it, if you 

would. What do you think the top two or three issues or solutions 

to these issues that we are discussing here should be, the SEC 

should consider in its October roundtable? What are the top areas 

of focus we should recommend to the SEC or see them consider? 

We will just start over here. Mr. Lauer. 

Mr. LAUER. Thank you, Senator. The roundtable is a technology 

roundtable, and as such, the number one thing should be market 

technology standards, policing, the kill switch that has been referred to on the panel, these types of issues. As I pointed out in 

my written testimony and my oral testimony, I think we should 

also—we need to get more creative. The SEC is, I believe as Senator Reed said, hopelessly outgunned. They need a pretty dramatic 

improvement in their technology capabilities. The market is a market based on technology. I am a technologist. I would never argue 

to move backwards. I would only argue to move forwards. 

But the SEC needs to take a market-wide approach to surveillance and enforcement. They need to build a strong market data 

plan. And if they could open access to market data, which is a controversial issue, they could really inspire some novel approaches, 

some creative thinking by independent programmers, a model that 

has been demonstrated time and again to be very successful for developing really interesting applications and inspiring new innovation, and that is something—a change in mindset that I would be 

very pleased to see. 

Senator CRAPO. Thank you. 

Mr. Brooks. 

Mr. BROOKS. I think our sense would be that perhaps three 

things for the technology crowd to look into. One would be order 

routing practices. Why are orders going where they are? What is 

driving that? 

Payment mechanisms, so maker-taker payment for order flow internalization. At some point, it is all about the money, so I think 

that is an important conversation to have regarding technology. 

And finally, we are concerned and our clients are concerned 

about the sense of unfair advantage that market data aggregators 

are giving to others and the sense that you get a view of the horse 

20 

race’s finish before anybody else, and I think technology needs to 

address that. 

Senator CRAPO. Thank you. 

Mr. Concannon. 

Mr. CONCANNON. Well, obviously, this roundtable was scheduled 

because of the summer of technology mishaps that we experienced. 

I think the focus will largely be on the proper testing that we deploy, the processes that we put around our new code that we roll 

into production, both exchanges and broker-dealers. 

But I hope the focus will be more around what happens when 

something goes wrong. We will always have bugs in our code. We 

will always have network gear breakdown. We will have networks 

flat. Those all cause disruptions that we have to build risk management procedures around. So we will never get rid of the bugs. We 

will never get rid of the mishaps. But it is how we respond to them 

that is more critical. 

I actually think a very simple adjustment to the SEC’s rule on 

market access is all that needs to be made. If we—we already have 

pretrade covered, so if everyone complied with pretrade, we are 

going to protect ourselves from what goes out the door. If we install 

these kill switches at the exchanges that are not that difficult to 

deploy, we can make the kill switch setting part of your market access obligation. So a broker has to justify his setting in the kill 

switch to the SEC when they come in and inspect. 

And the final piece that I mentioned, the drop copy piece, that 

covers your post-trade. So even if you miss something, even if an 

exchange creates risk for you because of an outage, you will still 

know on your post-trade, your drop copy, that there is someone 

trading in your name and you can check that against your risk procedures. 

And all three items would be part of the market access rule and 

would be all part of your procedures that you roll out for the SEC 

when they examine you. 

Senator CRAPO. Thank you. 

Mr. Tabb. 

Mr. TABB. I agree with a lot of what Mr. Concannon said about 

the kill switches and risk issues. One of the other issues, though, 

is that to a certain extent, some of these rules that the SEC has 

put in actually have not done—have not been specified properly 

and actually do not really work. And so I think the SEC really 

needs to do a better job in terms of how they specify some of their 

rules, like the direct access rule did not help Knight. It is supposed 

to be across asset class, but nobody has got cross-asset class capability now. 

Linked markets—it is very easy to do pretrade risk in a single 

market, but once you start trading across 50 markets, it becomes 

very hard to manage all that pretrade risk and you wind up with 

people raising their credit limits just so that they do not have to 

deal with it. 

The large trader rules were specified out of the wrong part of the 

data base that does not actually have trade data from the dealers. 

It would be nice if they actually took the time to actually understand what they are specifying. 

21 

So, now, getting back to my other thought of defragmenting the 

market, so if you look at market data, the issue is if I have a market and I am a market maker, even if no one trades there, I have 

got to quote every name that I am going to quote. So if I have two 

markets, all of the liquidity is here but I decide to quote over here, 

as well, so I have got all of a sudden twice as many quotes, which 

is kind of on a logarithmic scale in terms of amount of market 

data. So if we start pruning back the number of exchanges and licenses, we will wind up actually minimizing some of the market 

data challenges. 

And last is we really do need a consolidated audit trail and a set 

of regulators that can actually look over this stuff, because at the 

end of the day, if the SEC is bringing people to task, we will have 

a little bit better confidence that they have their eye on the switch, 

you know, their eye on the wheel. 

Senator CRAPO. Thank you very much. 

Mr. LAUER. Senator, if I may, just a quick comment—— 

Senator CRAPO. Yes. 

Mr. LAUER. ——along the lines of the consolidated audit trail, 

another important idea. The problem with the consolidated audit 

trail, while it is a fantastic idea and critically needed, it is years 

away. If we right away said, from now on, when you put a quote 

into the market, you have to include a unique ID number, either 

on a per account basis, like the consolidated audit trail specifies, 

or on a supervisory individual basis, and that ID number is propagated not publicly but down to regulators, into their market data 

plan, it would have a dramatically chilling effect on manipulative 

behavior and it would allow regulators to quickly reconstruct what 

happened within the markets. It would allow them to enforce the 

existing rules. And it would also provide a contact point to quickly 

identify what is going on in an emergency. And I believe, technologically, that is a very easy task for current exchanges and their 

customers to take. 

Senator CRAPO. Thank you. 

Chairman REED. Thank you very much, Senator Crapo. I have a 

few other questions. My colleague has to depart for an interview, 

but I want to thank him. I thought it was an excellent question, 

to try to focus on the SEC panel. As you point out, it is generally 

a technology focus. 

We have talked about technology, but also really important policy issues, the number of orders that are available, et cetera, and 

I just have two general questions. And first, Mr. Tabb and others 

that might want to comment, one of the things that has happened 

over the last several years is the proliferation of these dark pools 

and it raises the question of should there be a sort of uniform set 

of rules or conduct or behavior that apply to the dark pools as well 

as to the lit exchanges, and just any thoughts you might have. 

Mr. TABB. A very good question. They are definitely regulated in 

separate ways and the exchanges would certainly like an even 

playing field. And to a certain extent, I agree with that. 

The one challenge academically, and to a certain extent—and I 

think Mr. Brooks was talking a little bit about this, I think, earlier—I think it was Mr. Brooks—is that what Reg NMS did was infuse a single kind of market structure, a fast market priority over 

22 

slow markets, and what winds up happening is that once you wind 

up having a trade-through rule and you wind up having the same 

priorities across markets, in effect, what happens is the markets 

become tighter, more tight, more closely linked together, and problems can cascade through them. And so by then even tying together 

the dark pools with the exchanges in a trade-through mechanism, 

what you are going to—you might even create more fragility because then everything has to work exactly the same way, and keeping, you know, 13 exchanges and 50 dark pools lined up like that 

may be really difficult. 

One of the answers may actually be to get rid of the tradethrough rule and let markets develop a little bit more naturally. I 

think that was Mr. Brooks. Maybe it was Mr. Concannon was talking about that earlier. And that one market structure actually does 

not fit all. What you may want to actually do is actually what Mr. 

Lauer said, is have some sort of trade-at rule which basically says, 

you know, you cannot have de minimis price improvement and you 

need to price improve at least a half a tick or something like that 

to bring more liquidity into the market centers. 

But, by and large, it is a complicated—it is a complicated issue. 

I do not know what the right answer is. 

Chairman REED. I concur. 

[Laughter.] 

Chairman REED. Any other comments on this question, and then 

I have one more general question. Mr. Concannon. 

Mr. CONCANNON. Sure. I am actually fairly sympathetic to the 

exchanges’ situation. They are—they do have competition in the 

market called the dark pool. They are subject to heightened obligations as an exchange. But dark pools are registered. They are registered ATSs. They are subject to Regulation ATS. So they do have 

some of the components of the exchange regulation on them, as 

well. 

I think the one thing I am a little bit cautious about is the innovation in our market actually came from—not from the traditional 

exchanges, but from the original ATSs in our market. And today, 

those exchanges are actually former ATSs that were purchased by 

the exchanges. So I am concerned if we put too much regulation in 

the over-the-counter market for ATSs or dark pools that you will 

dampen that innovation in a market that we have enjoyed for 

many years. 

The other concern I have around dark pools is that it is a place 

for the buy side, people like Mr. Brooks, to feel comfortable about 

how their orders are handled and traded and not being pushed into 

the displayed market where people can find their orders and have 

an impact on the market. So there is a protective mechanism sitting inside the dark pool that is valued by the buy side and needs 

to be protected. 

Chairman REED. Mr. Brooks, you have a comment. 

Mr. BROOKS. I do, and I appreciate that, Mr. Concannon, because 

we do need protection because our orders are larger and a lot of 

the marketplace today is trying to identify our order flow and trade 

against it. So we are paranoid about that, and we should be, and 

I would suggest we have always been paranoid about that. So that 

is not new news. 

23 

But in a perverse way, the dark pools’ execution size, I believe, 

is not much greater than the lit markets, 200 shares. So what it 

was designed for, which might be to rest and hide order flow but 

be willing to trade, not get picked off, not be identified, it is not 

really accomplishing that for the most part. So that begs the question of what is going on in dark pools, and again, I think we all 

are somewhat challenged by truly understanding what is happening there and that needs further examination by all parties. 

Chairman REED. Thank you. 

If you have a quick comment, then I have one more question, Mr. 

Lauer. 

Mr. LAUER. Sure. I would just agree that I do believe that some 

unification of rules is necessary across venues. I think that is very 

important. And I think that, as I said before, the burden to execute 

on a dark pool should be much greater than executing on a lit exchange because you are removing information and liquidity from 

the public domain and lit exchanges. 

Chairman REED. You talked about the dark pool. Let us shift 

focus to the exchanges, which now are for-profit enterprises with 

proprietary operations, et cetera. And there have been some questions, concerns raised about proprietary data feeds, customers getting advantages over other traders, and the whole issue I think you 

raised, Mr. Brooks, in terms of your testimony, just about the 

standard of behavior that grew up in what was a utility more than 

anything else and now is a for-profit enterprise. So any comments 

that you might have, and I will begin with you, Mr. Brooks, about 

any things that we should do given the nature of these exchanges 

as for-profit vehicles and their issues of proprietary feeds, colocation, access. That was brought up. Any comments. 

Mr. BROOKS. So, again, you have picked a very tough question 

to pose to everybody in the industry. We certainly do not have the 

answers here, but it is challenging when exchanges have a for-profit motive and are interested in growing volume, and investors are 

not really interested in volume. They are interested in liquidity. 

And so those are two really different things. 

I am certain that exchanges can be profitable and can work well 

as a for-profit enterprise, but perhaps we need to understand really 

what their role should be going forward, who they should be serving, and by the way, what is the role of a broker-dealer today. 

These lines, as we stated earlier, have really become blurred and 

we need some guidance here. We need to bring together some great 

minds to really think through what does it mean to have these different roles and how should the—it is sort of a Glass-Steagall question. What is appropriate to be separate? 

We are troubled by the blurring of the lines. We are troubled by 

market data aggregation and dissemination selectively. Certainly, 

I can understand that data should be gathered and it can be sold 

and we are OK with that, but equal access important. 

You know, when we think about things, when we talk to clients 

and shareholders, we are interested—they are interested in fairness and a sense of balance, and our Chairman, Brian Rogers, always says, how do we get back to fairness and balance? And I 

think that is a good question to always be asking yourself. Are 

things as fair as they could be? 

24 

You know, we have a group of terrific, dedicated traders every 

day trying to find fairness in the marketplace for our investors and 

they do not feel so good about things. Things are moving on us. 

Things are—we are getting identified. People are taking advantage. 

There is opportunity being taken away from investors. It is the 

worst I have ever seen in my career, and I have seen a lot, not 

maybe as much as you have or others, but we have seen a lot of 

different things and it is a troubling time. 

Chairman REED. Other comments? Mr. Concannon. 

Mr. CONCANNON. I agree that it is a very difficult question 

around proprietary trading—proprietary feeds that come out of the 

exchanges. If you look around the world, most markets do not have 

a consolidated feed. It is all—Europe is all based on the feed that 

comes from the exchange and the direct exchange. And so, commercially, people consolidate those feeds. 

I am encouraged when we think about in the U.S. that the proprietary feeds are being consumed by investors. Some of the biggest 

consumers of those proprietary feeds are some of the retail online 

firms. They do push those proprietary feeds onto their Web site. 

They do do a form of consolidation. And when those retail orders 

come into the market, they are executed based on the proprietary 

feed. So there is some fairness being in terms of how the proprietary feeds make it out to the investing public and how their orders 

are treated under the proprietary feeds. 

But what that leaves me with a question, is then what is the 

value of our consolidated feeds, and I was more shocked that—I 

think the fact that they were so slow and went unnoticed by the 

industry kind of speaks volumes in terms of their value to the industry. 

Chairman REED. Anyone else? Mr. Tabb. 

Mr. TABB. Yes. I kind of agree with Chris. I think that most professional investors—and I am not as familiar with the retail side, 

Chris would be much more familiar with it. On the institutional 

side, most of the large brokers who are servicing the large institutions use proprietary feeds. A lot of their algos and technologies are 

based off that. I do not know necessarily who uses the consolidated, 

the aggregated feed, the sites, things like Yahoo!. 

As we start getting issues around colocation and governance of 

that speed, I am—even if we ban—let us say we ban proprietary 

feeds and we only use the aggregated SIP feed. The issue also then 

becomes is where is it being intercepted and read, and with the 

speed of light, someone who reads it in New Jersey is always going 

to get it before someone who reads it in California and how do you 

manage that. And I am not sure how you wind up delaying it so 

everybody gets it exactly at the same time. 

Chairman REED. Your testimony was a good lesson in physics, so 

thank you very much. 

Mr. Lauer, you get a final comment, and then I will summarize. 

Mr. LAUER. Yes. I think as far as colocation goes, there is a case 

to be made for eliminating colocation. The argument that is often 

made against it is exactly what Mr. Tabb has said. I think that, 

right now, if you can think about it, though, colocation has a very 

small radius of equality. You know, it is a very limited area in 

which people are equal. So if you eliminate that, you at least exVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
25 

pand the boundary and widen the opportunity to many more participants. You can reduce the costs, as well. 

I do think there is a case to be made for it. As Mr. Brooks said 

in his opening statement, which I thought was illuminating, there 

is no other regulated industry in which access to information is 

sold for an advantage by somebody who can act before someone 

else. To me, colocation in some ways does reek of nonpublic information. I have a server. It is moving very fast. I can receive a piece 

of market data, analyze it, and act on it before many people have 

even received that piece of market data. And again, in my written 

testimony, there are several studies that have demonstrated that 

this race to zero is having no effect—no beneficial effect on market 

quality. 

I think as far as the number of exchanges in the for-profit exchange model goes, I think what we need is a diversity of business 

models. Right now, there is pretty much only one business model 

in the marketplace. That is the maker-taker model. And so I think 

that it is—the environment is ripe for innovative ideas, and, of 

course, in my work with IEX Group, that is what we are working 

on. But I would like to see many more like that. So we could have 

different forces of defragmentation reducing identical business 

models, but coming up with innovative new ways that really appeal 

to the investor community rather than the trader community, and 

that is what the maker-taker model does. The incentive structure 

is very skewed toward high-speed trading and volume rather than 

liquidity, which is a major distinction that needs to be drawn. 

Chairman REED. I have just one final question which my staff reminded me, and this is in the wake of the volatility we have seen 

in the oil commodities markets. The inference in a lot of what we 

talked about today were equity markets, et cetera, but the interaction of electronic funds trading, commodity markets, high-frequency trading, et cetera, raises another issue about volatility. 

And this always comes up in the context, I think, particularly of 

oil and commodities. Is there a way to manipulate these markets, 

and either wittingly or unwittingly, is there the possibility, the potential, or the reality of manipulation, particularly given the incentive of oil to everything we do? And you might want to comment, 

Mr. Lauer, and then I will ask Mr. Tabb. 

Mr. LAUER. Yes. The answer is simply, yes. Absolutely, there is 

a way to manipulate prices and markets, especially with the current speed of systems right now, and what we see sometimes, 

which are these what are called illiquidity contagions or these 

miniflash crashes. There is well-documented evidence of practices 

such as quote stuffing, which is to slow down the channel of a direct proprietary feed in order to pick off participants that are slower or unable to keep up with a high volume of data. 

It is, in fact, well documented in one study that we see what is 

called comovement of message flow within channels, which is a 

rather shocking conclusion. Channels from a proprietary feed perspective are alphabetically distributed and, therefore, completely 

random, and you should expect to see no movement in the A 

through C channel. You would expect to see comovement of stocks 

in the same industry or exposed to the same macroeconomic factors. But the idea that there is going to be movement on a stock 

26 

because of the letter it begins with is perfect evidence that there 

is manipulation going on. That also leads to things like stop hunts, 

very manipulative behavior, and there is no way to figure out who 

is perpetrating that, which is one reason why I think this unique 

identifier attached to quotes is an absolutely critical issue and 

something that could be moved on very quickly. 

Chairman REED. Mr. Tabb, you have a comment, and then I will 

conclude. 

Mr. TABB. The way I want to answer that is yes and no. I think 

what Mr. Lauer is saying is absolutely true in the short term, very, 

very short term. I think there is an ability to manipulate stocks, 

especially in low liquid environments. But, generally, that manipulation is only going to take a little bit of—a short period of time 

from the electronic trading crowd, because, generally, the length of 

time they are holding a position is pretty short. So if they are buying 1 minute, they are selling the next minute. So they are only 

locking in small increments. 

That said, there are people who can push markets. The people 

who push markets actually are not the short-term holders. They 

are longer-term holders or intermediate-term holders because they 

have capital at stake. They are willing to push a position for, you 

know, days or weeks, and those tend to be more hedge fund-oriented type organizations. But if you are thinking of the traditional 

short-term electronic trading guy, I think to have an impact over 

a couple of minutes, yes. Impact over a day, pretty hard. You know, 

if you are going to have impact over a day, it has got to be somebody with much deeper pockets. 

Chairman REED. Thank you. 

Gentlemen, thank you for excellent testimony. I think what you 

have really exposed is the complexity of these issues, and there are 

not just one or two. There is a series of interrelated issues. And I 

think, also, the need to begin to act promptly to address all of these 

issues, to give the investing public confidence that the system is operating fairly. I think this notion that you said very well, Mr. 

Brooks, about fairness, I mean, we have recognized benefits, obviously, from the increased liquidity, from the decreased spreads, 

that now we have to sort of step back and see at what cost and 

how do we make improvements, not just simply keep pressing 

along. 

I must say, though, I did get some reassurance, with a 51⁄2-yearold daughter, that iTunes does provide a drop copy. Thank you, Mr. 

Concannon. 

[Laughter.] 

Chairman REED. I am making a note of that so that we have accomplished one objective today. 

But I think, again, just to say, this is an issue that will not go 

away. In fact, with technology, it will get even more complicated. 

I am pleased that the SEC is undertaking the technological roundtable, but I would like to be able to, with the concurrence of my 

colleague, Senator Crapo, do additional hearings, because I think 

you have raised some extraordinarily complicated issues in a very 

thoughtful way and we have to do a lot more work, along with the 

regulators, to come up with sensible responses. 

27 

Mr. Tabb, your point, I think, is always well made. Try to do no 

harm. Try to prioritize changes that are the least disruptive and 

the most effective, and that is always good advice, so thank you for 

that. 

But, gentlemen, thank you so much. I have one other statement 

to make for the record. 

First of all, I want to thank all of our witnesses for testifying 

today. 

[Laughter.] 

Chairman REED. We appreciate both the time and effort that you 

have made. That should be obvious. Thank you so much. 

Now, if you have additional written statements, please feel free 

to submit them. You may receive additional questions from my colleagues. Please respond as rapidly as possible. I will ask my colleagues to submit their questions no later than next Thursday, 

September 27, and please respond as quickly as possible to that. 

If any of my colleagues want to make a statement for the record, 

it will be included by unanimous consent in the record. 

In addition, I ask the statement of Public Citizen be included in 

the record, and hearing no objection, so ordered. 

Chairman REED. With that, thank you very much, gentlemen. 

The hearing is adjourned. 

[Whereupon, at 11:28 a.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 

28 

PREPARED STATEMENT OF DAVID LAUER 

MARKET STRUCTURE AND HIGH-FREQUENCY TRADING CONSULTANT, BETTER MARKETS

SEPTEMBER 20, 2012 

Good morning Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee. Thank you for the invitation to Better Markets to testify today. 

Better Markets is a nonprofit, nonpartisan organization that promotes the public 

interest in the domestic and global capital and commodity markets. It advocates for 

transparency, oversight, and accountability with the goal of a stronger, safer financial system that is less prone to crisis and failure, thereby, eliminating or minimizing the need for more taxpayer funded bailouts. Better Markets has filed almost 

100 comment letters in the U.S. rulemaking process related to implementing the financial reform law and has had dozens of meetings with regulators. Our Web site, 

www.bettermarkets.com, includes information on these and the many other activities 

of Better Markets. 

My name is David Lauer and I am a Market Structure and High-Frequency Trading Consultant to Better Markets. I’m also consulting for IEX Group, Inc., a private 

company that is in the process of building an investor-owned and investor-focused 

U.S. equity market center. Prior to working with Better Markets and IEX Group, 

I worked as a senior quantitative analyst at Allston Trading and before that at Citadel Investment Group. Prior to my career as a researcher and trader, I worked at 

Tervela where I helped to design hardware and specialized in studying and understanding the complexities of the rapidly evolving electronic marketplace both before 

and after Reg NMS was implemented. I have a Master’s degree in International Economics and Finance from Brandeis University. I grew up in Southern New Jersey. 

Introduction 

On May 6, 2010, the U.S. stock market demonstrated some of the most unpredictable and disturbing behavior in its 218 year history. Over the course of just 20 minutes, the stock market plunged and snapped back up, losing and then regained 

nearly $1 trillion in market value. Nobody had ever seen anything like it. The crash 

began in the S&P E-Mini Futures market but quickly spread to and overwhelmed 

the equity markets. That day I was in the center of the storm, working on the highfrequency trading floor of one of the largest S&P 500 E-Mini Futures trading firms 

in the world, on the global equity trading desk. 

As I watched the market crash, I witnessed something unthinkable: the market 

simply disappeared. For what felt like an eternity, but was more likely 30 seconds 

to a minute, there were no bids or offers displayed in the market for major stocks 

and ETF’s such as SPY (the S&P 500 Index ETF). 

None of us knew what to do or what would happen next. Immediately before the 

market disappeared, our firm, like other high-frequency trading firms, withdrew our 

orders from the market because we did not understand what was happening, did 

not trust our data feeds and had no obligation to remain active in the market. Anybody who seeks to minimize the role that high-frequency trading had in the Flash 

Crash either was not on a trading floor that day or has an interest in maintaining 

the current unregulated status quo. 

When more than half of the liquidity in the stock market is able to be pulled from 

it in a matter of seconds, dramatically worsening an unstable situation, something 

is dreadfully wrong. 

U.S. equity markets are in dire straits. We are truly in a crisis. Over the past 

three decades a technological revolution has swept over Wall Street. In many ways, 

this has dramatically improved the efficiency of capital markets relative to past decades: reducing spreads and volatility, and helping them to more effectively perform 

their core functions of price discovery and capital formation. Regardless of the arguments about this extremely volatile issue, we must judge the evolution of capital 

markets around these characteristics of spread width, price volatility, price discovery and capital formation as well as other characteristics such as the price impact of large institutional orders and catastrophic event frequency. 

The past decade of this revolution has been marked by two primary trends: extreme marketplace fragmentation and rapid growth of high-frequency traders as the 

primary suppliers of liquidity. As of today, there are 13 lit exchanges and more than 

50 dark pools/internalization venues. Exchanges account for between 65 percent and 

75 percent of the market, and the Dark Pools, with 18 tracked by Rosenblatt, account for 12 percent–15 percent. The balance is attributed to internalization, including OTC block trades and wholesalers. This is a far departure from the stock market of the 20th century that was well understood by most Americans. If you were 

to ask the average retail trader or even sophisticated institutional investor what 

29 

1http://www.nanex.net/aqck/aqckIndex.html 

2 Rob Iati, ‘‘The Real Story of Trading Software Espionage’’, http://advancedtrading.com/algorithms/showArticle.jhtml?articleID=218401501, July 10, 2009. 

happens today when they send a buy or sell order to the market, few if any would 

be able to describe the labyrinthine path that order takes to be filled. 

Complexity has become the hallmark of the new electronic landscape, whether it 

is in the form of a multitude of venues and participants or the advanced algorithms 

that many of them are using to analyze incoming market data. While complex systems can often provide elegant solutions to intractable real-world problems, they can 

also spin out of control in unexpected ways. Often the interaction of these nonlinear 

systems is difficult or impossible to predict. In the U.S. equity market, we have seen 

first-hand glimpses of what can happen as overly complex systems interact in nonlinear ways. The incidents are becoming more common, and include: 

• The Flash Crash in May, 2010, was set off by a single large trade estimated 

at $4.1 billion in the S&P 500 E-Mini Futures Market. The cascade led to 20 

minutes of extreme volatility, wiping out nearly $1 trillion of market cap before 

quickly and inexplicably recovering. The total economic cost of this event is 

unmeasured, but certainly huge. We were lucky it didn’t happen near the market close—had the U.S. market closed before it recovered, the result could have 

been total economic disaster because money would have hemorrhaged out of the 

stock market overnight. 

• In August, 2011, the stock market swung up and down by over 4.4 percent on 

four consecutive days, alternating up and down days. It was wild, unprecedented volatility—only the third time in history that had happened, with the 

second time having been 3 years prior, during the crash of 2008. While the European crisis was becoming a more important issue at the time, this volatility 

was not warranted by major economic changes or historic macroeconomic 

events. This was computer-driven volatility. 

• ‘‘Mini flash crashes’’ occur on a near-daily basis in individual stocks. Nanex has 

documented almost 2,000 instances of individual irregularities in stocks since 

August 2011. 1 Single-stock circuit breakers have failed to stem the tide of these 

incidents. 

• IPO’s in Facebook and BATS (itself an Exchange) have gone horribly wrong due 

to technological ‘‘glitches,’’ continuing to sour the already languid market for 

IPO’s and costing untold numbers of jobs as companies cannot raise the capital 

they need to expand and hire. 

• Few realize how lucky we were on Tuesday, July 30. An order to sell nearly 

$4.1 billion in the S&P 500 E-Mini Futures Market, the same size as what precipitated the Flash Crash, was executed three seconds before the market closed. 

There simply was not enough time for the waterfall of May 6, 2010, to repeat 

itself. What happens the next time when that same order is sent in a couple 

of minutes sooner? While some may point to this as evidence that the market 

worked, there have not been any changes in market structure since the Flash 

Crash other than circuit breakers, which are not active in the final 25 minutes 

of trading. 

• On Wednesday, July 31, Knight Capital Group—one of the largest market making firms, an official Designated Market Maker on the NYSE, had a ‘‘software 

glitch’’ according to their CEO. The result? A loss for them estimated at $440 

million, untold economic losses for retail investors with stop-loss orders in one 

of the almost 140 stocks that were affected and further erosion in investor confidence. 

There is no doubt that electronic trading has tremendous value to offer, at times 

enhancing the smooth functioning of the stock market and increasing competition, 

thus driving down the spread that the average investor has to pay to buy or sell 

a stock. HFT has been so successful that it has taken over the stock market, now 

accounting for between 50 percent–70 percent of equity market volume on any given 

day. Fortunes have been made, with estimated annual profits exceeding $21 billion 2

at its peak, and estimates varying but still in the billions of dollars today. 

What we must be concerned with is whether the pendulum has swung too far, 

and whether the nearly unregulated activities of anywhere from 50 percent–70 percent of stock market volume should be permitted to continue down this path. For 

the proponents of HFT to make the case that the market is functioning well, or that 

only incremental reforms are needed rather than wholesale changes, they must 

make the case unequivocally that the market satisfies the aforementioned characVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00033 Fmt 6621 Sfmt 6621 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
30 

teristics of tightening spreads, decreasing volatility and is a more efficient and lowcost mechanism for price discovery and capital formation today than at any time 

in the past, and that proposed reforms are not even worth trying. 

Despite the large quantity of HFT-funded research touting the benefits of HFT 

(lower spreads, increased liquidity, lower volatility), there are also many research 

studies that prove the opposite. However, a higher-level debate on the impact of 

HFT on today’s market should also consider the fact that catastrophic event frequency has increased, IPO’s have dramatically dropped and retail investors have 

been fleeing the stock market in droves. The flight of the retail investor during a 

period of incredible stock market returns is a sure sign that this exodus is a result 

of mistrust rather than economic conditions. Investor confidence is nonexistent, with 

only 15 percent of the public expressing trust in the stock market in the latest Chicago Booth/Kellogg School Financial Trust Index—8 percent lower than those that 

trust the banks! The figure that follows is one of the most disturbing illustrations 

of the flight of the retail investor: 

Historically, the correlation between market performance and net flows is undeniable. Despite the rally over the past 3 years, fund inflows have not followed. Since 

the Flash Crash in May 2010, over $283bn has flown out of the U.S. Equity markets. Over that time period, the S&P 500 has risen by over 21 percent. 

This trend, along with unpredictable and increasing volatility, has also driven 

companies away from the stock market. From 1990–2000, the average number of 

firms going public each year was 530. Since 2001, that number has plummeted to 

125. When companies are able to easily go public and access large amounts of capital, they are able to grow, expand and hire. When fragility, volatility and mistrust 

are the defining characteristics of the market, companies do not see an IPO as a 

viable means to raise capital, or in their long-term best interests. That has been the 

reality in the market for over a decade, becoming most acute since 2008. This is 

the connection from the market to the economy and the country as a whole, and 

it demonstrates how changes in market structure are affecting nonmarket participants. The void in the IPO market has correlated strongly with the U.S. unemployment rate over the past decade. 

31 

3Smith, Reginald, ‘‘Is High-Frequency Trading Inducing Changes in Market Microstructure 

and Dynamics?’’ (June 29, 2010). Available at: http://arxiv.org/PSlcache/arxiv/pdf/1006/ 

1006.5490v1.pdf 4The Hurst exponent (H) is a measure of self-similarity, the autocorrelation of a time series. 

Computed using intraday data, it measures the tendency of a time series to form clusters or 

remain random. Random price oscillation is the cornerstone of our understanding of the stock 

market, and how the price discovery process occurs. 

It’s important to note that these numbers are before 2012, and the debacles of the 

BATS and Facebook IPO’s. Those technology ‘‘glitches’’ may well end up costing us 

countless jobs that cannot be realized because companies are increasingly reluctant 

to use the public marketplace to raise funding. 

It does not make sense to address a problem before establishing that one exists. 

While it is clear that the symptoms of the problem—increasingly frequent market 

disruptions, retail investor flight and a stagnant IPO market—are dramatically 

demonstrated, it is instructive to examine the current state of U.S. equity markets. 

I will seek to demonstrate that market quality has not been improved by high-frequency trading, and in fact that the market is more fragile than ever, to the degree 

that individual firms, and even individual servers, can have a disproportionate impact on the entire U.S. equity market and by extension the global market. I will 

also demonstrate that the new, fragmented market is detrimental to long-term investors. Finally I will propose remedies to address these problems. 

Market Quality and High-Frequency Trading 

To suggest that regulatory changes are necessary to address problems in current 

market structure, it must be demonstrated that current market structure is not 

serving the needs of long-term retail and institutional investors, and that the current regulatory regime is insufficient to address problems in the market. To begin 

with, it must be demonstrated that there has been a material, adverse change in 

market structure that must be addressed. 

In an interesting paper published in 2010, 3 Reginald Smith asked the question 

‘‘Is high-frequency trading inducing changes in market microstructure and dynamics?’’ He went on to demonstrate that while historically, the Hurst exponent 4 of the 

stock market has been measured at 0.5, consistent with Brownian motion and our 

general understanding of how the market functions on small time scales, since 2005 

and Reg NMS that value has been increasing. While this is certainly an esoteric 

statistical discussion, his conclusion is striking: 

we can clearly demonstrate that HFT is having an increasingly large impact on the microstructure of equity trading dynamics . . . this increase beVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00035 Fmt 6621 Sfmt 6621 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T 92012002.eps
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5More information on this can be found here: http://select.nytimes.com/2007/08/18/business/18nocera.html. 6 Cespa, Giovanni, and Foucault, Thierry, ‘‘Illiquidity Contagion and Liquidity Crashes’’ (May 

8, 2012). Available at SSRN: http://ssrn.com/abstract=1804351. 

comes most marked, especially in the NYSE stocks, following the implementation of Reg NMS by the SEC which led to the boom in HFT . . . volatility 

in trading patterns is no longer due to just adverse events but is becoming 

an increasingly intrinsic part of trading activity. Like Internet traffic Leland, et. al. (1994), if HFT trades are self-similar with H > 0.5, more participants in the market generate more volatility, not more predictable behavior. 

This is one of several shocking conclusions that we will examine in this testimony. 

It also speaks to the detrimental impact that the complexity of HFT algorithms, and 

their nonlinear interactions, has on market microstructure. These algorithms are 

complex enough that it takes seasoned practitioner to understand them just in isolation, and nobody understands what happens as they interact with each other. The 

so-called ‘‘Great Quant Meltdown of 2007’’ 5 from August 7–10, 2007, was an ominous harbinger of what was to come. Many people aren’t even aware that there was 

significant turmoil in financial markets in early August, 2007 because of unexpected 

behavior of long-short quantitative equity funds. Many of these funds were holding 

the same undervalued/overvalued securities, and suffered great losses when they did 

not revert and entered a positive feedback loop of liquidation. A full discussion of 

this is outside the scope of this testimony, but it was an indication that, while they 

were not HFT strategies, seemingly simple long/short quantitative strategies were 

not well understood by those who wrote them, and they certainly didn’t understand 

the ramifications of their interactions with each other in the marketplace. 

Many HFT strategies have been poached from other firms, or arrived at independently by quantitative analysts using identical techniques. This is one of the main 

reasons we have seen such a massive investment in technology. The sophistication 

of your trading strategy is no longer a defining characteristic of its success, rather 

the number of microseconds that it takes your software to react to a piece of market 

data has become one of the most important factors of success in the HFT industry. 

The implications of this are grave. As we see on a nearly regular basis, algorithms 

reacting to one another, or to manipulative behavior by nefarious actors, can exhibit 

nondeterministic behavior. The ‘‘mini flash crashes’’ that Nanex documents on a regular basis are excellent examples of this nondeterministic behavior as algorithms 

enter positive feedback loops either with themselves or in relation to other algorithms. Many high-frequency trading strategies rely on correlation of securities with 

other assets and use price movements in different securities to inform the fair-value 

price of another security, through high-, medium-, and even low-correlation relationships. On a widescale basis, this can have unintended and nondeterministic consequences, including positive feedback loops in which liquidity is rapidly withdrawn 

from the market. 

Giovanni Cespa and Thierry Foucault wrote a paper in March, 2012, calling this 

type of phenomenon an ‘‘Illiquidity Contagion.’’ 6 They noted that the same type of 

positive feedback loop I have discussed here can cause a sudden drop in market liquidity, and shift the market to a new equilibria characterized by high illiquidity 

and low price informativeness. That a crash in the futures market could ‘‘infect’’ the 

equity market is another symptom of the increasing interconnectedness of global security markets—equity index futures, commodities, stocks/ETF’s and currencies are 

all now being actively traded by high-frequency traders. Using the aforementioned 

historical correlations has the unfortunate side effect of becoming self-reinforcing because many HFT models observe the same historical relationships and often trade 

assets in this manner. At the limit, when a positive feedback loop is loosed onto the 

markets-at-large, you can have a correlation=1 event—in other words, the Flash 

Crash. 

The increase in correlations is a well-documented characteristic of the new electronic marketplace. Correlations between stocks are as high as they have ever been, 

including during the crisis in 2008, as shown in this chart from Goldman Sachs: 

33 

7 JPMorgan, ‘‘Why We Have a Correlation Bubble’’, http://www.cboe.com/Institutional/ 

JPMDerivativesThemesCorrelation.pdf, October 5, 2010. 

According to JPMorgan, this ‘‘new normal’’ of persistently high correlations is 

driven by the macroeconomic environment, the increased use of ETFs and index futures, and high-frequency trading. 7 With the stock market moving in lock-step, this 

means that the traditional benefits of diversification that retail investors have relied 

on for decades are no longer there to protect them from dramatic moves in stock 

market indices. It also means that the market becomes a poor indicator of company 

value and performance, undermining one of its core functions. In addition, the increases in volatility and correlation drive options prices higher, which increase the 

hedging costs to businesses that pass those costs on to their customers. Furthermore, any increase in stock market volatility has a ‘‘negative wealth effect.’’ Retail 

investors are notoriously poor at timing market moves, and have a tendency to buy 

when the market is high and sell when it’s low. Increasing volatility exacerbates 

this behavior and costs retail investors money. 

It is clear that the structure of the market has changed dramatically since the 

advent of high-frequency trading, but that is not necessarily a bad thing. One could 

argue that the previous market structure was inefficient; the specialist model extracted unreasonably high rents for the service they provided, and that the benefit 

of tighter spreads in this new electronic marketplace outweighs the costs of a more 

highly correlated market. If indeed tighter spreads and lower volatility characterize 

this new, more efficient marketplace, there is a case to be made that the value far 

outweighs the cost. We are therefore confronted with these questions: 

1. Are spreads tighter, and tightening? Is volatility lower, and continuing to drop? 

Is the price discovery process efficient? Is the price impact of large trades acceptable? Are companies comfortable accessing capital by going public? Are regulators comfortable in their understanding of market mechanics, and able to 

effectively write new rules and enforce existing ones? 

2. Is this the best we can do, or is there a market structure under which total 

transaction costs to investors are even lower? Is there a market structure that 

is more stable, and one that will instill confidence for institutional and retail 

investors? 

The traditional mantra of the high-frequency trading industry is that HFT has 

helped to decrease trading costs by providing tighter spreads and lower volatility. 

One of the oft-cited studies in support of this claim was authored by employees of 

RGM Advisors, LLC, a prominent HFT firm. Another study was done by an emVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00037 Fmt 6621 Sfmt 6621 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T 92012003.eps
34 

8Zhang, Frank, ‘‘High-Frequency Trading, Stock Volatility, and Price Discovery’’ (December 

2010). Available at SSRN: http://ssrn.com/abstract=1691679. 9 Ibid. 

10 Cartea, Alvaro, and Penalva, Jose, ‘‘Where Is the Value in High Frequency Trading?’’ (December 21, 2011). Available at SSRN: http://ssrn.com/abstract=1712765. 11Kirilenko, Andrei A., Kyle, Albert S., Samadi, Mehrdad, and Tuzun, Tugkan, ‘‘The Flash 

Crash: The Impact of High Frequency Trading on an Electronic Market’’ (May 26, 2011). Available at SSRN: http://ssrn.com/abstract=1686004. 12 Ye, Mao, Yao, Chen, and Gai, Jiading, ‘‘The Externality of High Frequency Trading’’ (August 31, 2012). Available at SSRN: http://ssrn.com/abstract=206683. 13 Crow, Charles, and Emrich, Simon, ‘‘ ‘Real’ Trading Volume, Morgan Stanley Quantitative 

and Derivative Strategies Group’’, April 11, 2012. 

ployee of Credit Suisse, a major proponent of HFT. However, an increasing number 

of independent academic papers have demonstrated the opposite: 

• Watson, Van Ness, and Van Ness (2012) using Dash-5 data find that the average bid-ask spread from 2001–2005 was $0.022 (2.2 cents), while the average 

bid-ask spread from 2006–2010 was $0.027 (2.7 cents), a dramatic increase of 

22.7 percent. In addition they document increasing volatility as measured by 

the standard deviation of the price of stocks, from 0.13 for 2001–2005 to 0.161 

for 2006–2010, an increase of 23.85 percent. 

• Zhang (2010) found that ‘‘high-frequency trading is positively correlated with 

stock price volatility after controlling for firm fundamental volatility and other 

exogenous determinants of volatility. The positive correlation is stronger among 

the top 3,000 stocks in market capitalization and among stocks with high institutional holdings. The positive correlation is also stronger during periods of 

high market uncertainty.’’ 8 Zhang finds that estimated HFT trading volume is 

78 percent, explaining that ‘‘78 percent is clearly excessive if HFT is meant to 

provide liquidity. If HFT were to provide all of the market’s liquidity, the volume of HFT would still be at most 50 percent.’’ 9

• Cartea and Penalva (2011) 10 examine the impact of HFT on financial markets 

using a model with three types of traders: liquidity traders, market makers, and 

high frequency traders. The finding of their model is that high frequency traders increase the price impact of liquidity trades, increasing (decreasing) the 

price at which liquidity traders buy (sell). These costs increase with the size of 

the trade suggesting that large liquidity traders (i.e., large institutional traders 

making sizable changes to their portfolio) will be most affected by HFT. The authors also propose that HFT increases price volatility and doubles volume. 

• Kirilenko, Kyle, Samadi, and Tuzun (2010) 11 examine the behavior of high frequency traders in E-mini S&P 500 futures contracts during the events surrounding the flash crash. HFT patterns surrounding the flash crash are inconsistent with traditional market making. They conclude that while high frequency traders may not have caused the flash crash, their response to the high 

selling pressure exacerbated volatility. (This is certainly consistent with my experience on the trading floor that day.) 

• Mao Ye, Chen Yao, and Jiading Gai (2012) 12 point out two effects of high frequency trading: ‘‘First, it may enable investors to seize trading opportunities. 

Second, it may increase adverse selection problem for slow traders and generate 

negative externality. Our results indicate that the second effect dominates in 

the sub-millisecond environment. Also, an increase in the cancellation ratio or 

message flow also creates another negative externality. Stock exchanges need 

to continuously upgrade trading systems to accommodate more message flow. 

These costs, finally, are covered by fees from traders. However, the current fee 

structure only charges trades, not cancellations. Therefore, cancellation actually 

creates an externality for traders with true intentions to trade, who subsidize 

the traders with lots of cancellations.’’ 

From the industry, Morgan Stanley concluded in a recent report that institutional 

orders are having a much larger impact on asset prices now than in the period before 2007. They found that the maximum percentage of average daily volume that 

a Volume-Weighted Average Price trade (a very common institutional trading strategy) can handle without adverse price impact has declined from 10–15 percent to 

around 4–5 percent now. 13 They believe the primary reason for this is that the percent of volume attributable to natural buyers and sellers has declined by 40 percent 

when comparing the volume during 2001–2006 to that since 2008. 

These studies show a clear, detrimental impact to spreads, price impact and volatility. Because there are other studies pointed to by the industry that enable them 

to claim the opposite, it is instructive to not only examine the academic literature 

35 

14 Ibid. 15 Ye, Mao, Yao, Chen, and Gai, Jiading,‘‘ The Externality of High Frequency Trading’’ (August 31, 2012). Available at SSRN: http://ssrn.com/abstract=206683. 16 Ibid. 

and studies, but to look at the ultimate result. It is clear that long-term investors 

do not trust the market. The Morgan Stanley paper cited above concludes that the 

volume of trading attributable to institutional traders dropped from 47 percent in 

the period 2001–2006 to 29 percent since 2008, a decline of 40 percent. 14 It is clear 

that long-term investors are fleeing equity markets at unprecedented rates. It 

should also be clear that there are severe inefficiencies in the current market structure, and that indeed these inefficiencies are structural—they are not going away 

without structural changes. The HFT industry continues to make billions of dollars 

each year by exploiting these structural inefficiencies. While there have recently 

been marginal declining returns to scale, it has not stopped the performance and 

technology race, which the HFT industry realizes is the only way that they can differentiate themselves from one another. 

Structural Inefficiencies Have Created a Fragile Marketplace 

The new electronic marketplace has several structural inefficiencies. These are 

what have permitted HFT to become a destructive force in the market, rather than 

a passive liquidity providing mechanism. This should not be construed to say that 

all HFT is bad, but there are 2 important points to make—the structural inefficiencies present in the market have created a massive misallocation of resources into 

technology that provides no social benefit, and structural deficiencies in market 

structure have allowed for nefarious or accidental actions to disrupt the market. 

The overriding aspect in the current market that we should fear most is the inordinate impact that a single market participant, or even a single server, can have 

on the market-at-large. This is a grave concern from any perspective. Whether we 

are dealing with nefarious, predatory behavior such as quote stuffing and pinging, 

or simply accidental mistakes such as the Knight Capital fiasco appears to be, one 

thing should be clear: The market has become more fragile than we should expect 

or accept given the tremendous advances in technology over the past decades. 

These structural inefficiencies have been created by the unintended consequences 

of regulations: 

• The approval of the maker/taker model and Pay-For-Order-Flow deals. 

• The disappearance of affirmative market-making obligations. 

• The fragmentation of equity markets into lit and unlit market centers, with little regulation of the unlit centers. 

• The rubber-stamp approval of exotic order types without proper study or justification. 

• The unbridled latency race to zero without concern over the impact on markets, 

and the massive investment in technology required to keep pace. 

While proponents of the existing market structure will argue that they must be 

given a free market to allow capitalism and competition to fix any inefficiency, they 

ignore the fact that many of the inefficiencies have been created by regulation and 

must therefore by remedied by regulation. They must also be reminded of the consequences of unfettered, unregulated industries with negative externalities whose 

costs are not borne by the producers. In much the same way that polluting enterprises have to be regulated so that they bear the cost of negative externalities, so 

must HFT firms. 

In a ground-breaking study done at the University of Illinois at Urbana-Champaign, Mao Ye, Chen Yao, and Jiading Gai demonstrated the following: 15

• While aggressive investment in new technology to reduce latency has obvious 

benefits for market participants making that investment, it is unclear whether 

there is an associated social benefit when negative externalities are properly accounted for. 

• They examined two consecutive technological shocks that decreased latency 

from microseconds to nanoseconds. They found that those shocks ‘‘drastically increase both the trading speed and the cancellation ratio, which escalates from 

26:1 to 32:1. However, there is no impact on trading volume, spread, depth, or 

price efficiency.’’ 16

36 

17 Ibid. 18 Ibid. 19 Egginton, Jared F., Van Ness, Bonnie F., and Van Ness, Robert A., ‘‘Quote Stuffing’’ (March 

15, 2012). Available at SSRN: http://ssrn.com/abstract=1958281. 

• They go to conclude that ‘‘high-frequency trading may cause an adverse selection problem for slow traders’’ and that this effect ‘‘dominates at the sub-millisecond level.’’ 17

• They also demonstrate conclusive evidence for quote stuffing, a practice in 

which the infrastructure of data feeds is manipulated in order to slow down 

traders with inferior technology and to take advantage of this. They shockingly 

demonstrate ‘‘clear evidence of comovement of message flow for stocks in the 

same channel through factor regression. This result is consistent with quote 

stuffing, because message flow of a stock slows down the trading of the stock 

in the same channel, but does not have the same effect on stocks in a different 

channel.’’ 18 This claim is reinforced by Egginton, Van Ness and Van Ness who 

‘‘find that quote stuffing is pervasive with several hundred events occurring 

each trading day and that over 74 percent of U.S. listed equity securities experience at least one episode during 2010.’’ 19 Why is this such a shocking conclusion? Stock symbol distribution across channels is alphabetic—essentially random. You would expect comovement of message flow across industries or correlated stocks, but not based on an alphabetic distribution. This is clear evidence of market manipulation. 

• Finally they demonstrate that 50ms would be a reasonable ‘‘speed limit’’ for 

minimum quote life, as they find that 30–40 percent of orders are canceled 

within 50 milliseconds and they have a trivial if any contribution to liquidity. 

The elimination of these orders could have a $0.0000378 increase in quoted 

spread, or 0.5 share decrease in depth within 10 cents of the best bid and ask. 

In addition, limit order books without these orders have the same variance ratio 

(a measure of price discovery and efficiency) as order books with these orders. 

It seems that in the latency race to zero, it is those participants who are not engaged in this race that are paying the unintended costs. Market data feed volume 

has risen exponentially in recent years, and increasing technology investments are 

being borne by retail and institutional investors in the fees that they must pay to 

trade. The genesis of this problem was the maker-taker business model of the forprofit exchange/ECN/ATS. This business model is designed to compensate those who 

provide liquidity by charging those who take it. Almost every single exchange now 

makes money on the spread between the rebate paid to liquidity providers (previously market makers, now HFT firms) and the fees charged to institutional and 

retail investors to take liquidity. This has created a tremendous conflict-of-interest 

for exchanges, especially now that they are publicly traded and beholden to shareholders (at least in the case of Nasdaq, NYSE, and eventually BATS). They make 

money through volume and churn, and have little incentive to maintain fair, orderly 

markets. 

Another consideration with the maker-taker model is the complete lack of viable 

alternatives. Exchanges have had ‘‘glitches’’ and blow ups, notably BATS and 

Nasdaq during high-profile IPO’s. Yet their market share has not suffered because, 

frankly, there are no viable alternatives. This is not to say that there’s no hope. 

Other efforts are underway to provide an alternative business model, of which I am 

devoting my expertise and time to one of those potential alternatives. In our current 

environment, a two-pronged approach is critical: regulators must address structural 

inefficiencies, transparency, level playing field, antifraud and related matters, while 

allowing private industry’s innovation and developments to operate in a fair and 

open marketplace. 

The increasing fragmentation of the marketplace and the advent of pay-for-orderflow deals have led to a phenomenon called adverse selection. This means that profitable trades (from a market-making perspective) never reach the market. Retail 

and institutional order flow pass through a gauntlet of internalizers and high-frequency trading desks, which pick off any profitable order flow before it ever reaches 

the public, lit market. While these orders are filled within the NBBO, meaning that 

the originator of the order is no worse off on that particular order, market quality 

as a whole suffers. Natural buyers and sellers are virtually nonexistent under this 

structure, and the majority of the volume on the exchanges becomes ‘‘toxic flow’’ an 

industry term for orders that nobody wants to interact with. The end-product is consistent with the Morgan Stanley report cited above, although for different reasons 

than the authors of the report would point to. Other countries mandate significant 

price improvement to internalize order flow, but the SEC has not. 

37 

20Weaver, Daniel G., ‘‘Internalization and Market Quality in a Fragmented Market Structure’’ (May 19, 2011). Available at SSRN: http://ssrn.com/abstract=1846470. 21 Ibid. 22 Ibid. 

Dan Weaver, a professor out of Rutgers University has designed a research study 

to measure what the impact of dark pools and extreme fragmentation has been on 

the lit venues. He has found that trading in off-market venues such as dark pools 

directly impacts the spread in the lit markets, and that the cost of trading is 1.28 

cents higher in NYSE lit markets because of this. 20 Weaver goes on to say that ‘‘as 

the percentage of internalization increases, average trades will have an increasing 

impact on prices. Finally, for all market segments, higher levels of internalization 

are associated with higher levels of return volatility.’’ 21 And in fact, in his literature 

review, Weaver reviews two studies that demonstrate that ‘‘the internalizing of uninformed order flow by discriminating dealers reduces the number of uninformed orders for the nondiscriminating dealers to spread their informed losses over. The result of this is a widening of spread charged by the nondiscriminating dealer.’’ 22

The current level of fragmentation and complexity is helpful to HFT firms. They 

are the masters of the complexity, some of the few actors in the market that understand the relationships and interconnectedness and realize high returns based on 

arbitrage. They also use these unlit venues as signaling mechanisms, and many of 

these venues cater to them, for a price. 

Adding to the complexity in the current market structure is the proliferation of 

exotic order types. While the SEC deliberates extensively on any rule change and 

regulation, the hurdle is far lower for new order types. It is extremely rare to have 

the SEC refuse an exchange’s request for a new order type, regardless of whether 

the order type does anything to further price discovery or make markets more efficient. 

Many of the newest order types appear to have been designed by the HFT firms 

themselves, with little to no utility outside of their automated strategies. It remains 

completely unclear what social utility comes of hidden midpoint pegs, sliding, hideand-slide, post-only, PNP, PL select and the rest of the alphabet soup of order types. 

Even sophisticated sell-side algorithmic trading desks rarely use anything other 

than a limit order, an order for the opening/closing auction and maybe a midpoint 

or peg order. HFT firms thrive on this contrived, structural complexity. They make 

it their business to understand these order types and how best to exploit them. 

What Can Be Done? 

The current structure of the U.S. equity markets is demonstrably unwieldy, overly 

complex, and extremely fragile. It is subject to manipulation, whether nefarious or 

accidental, on a daily basis. Spreads are no longer tightening and volatility is no 

longer dropping. The price impact of large, institutional orders is rising. 

Technological mayhem is more frequent and likely to increase. These events are 

not technology ‘‘glitches’’ and ‘‘bugs,’’ as the industry and its allies like to 

dismissively refer to them as, because they wreak havoc on the market in multiple 

material ways. It is simply a matter of time before we have another catastrophe of 

the same magnitude or worse than the Flash Crash. The next time it happens, we 

may not be so fortunate with regard to the timing—it was only luck that the Flash 

Crash didn’t start in the morning, inciting markets around the world to crash, or 

at 3:45 p.m. EST, with the market closing after the drop, but before it could recover. 

If this were to happen, there would be an overnight exodus from the market with 

disastrous consequences for the U.S. economy. 

In addition, until confidence in markets is restored, retail investors will continue 

to stay away, regardless of the returns they’re missing (as has been shown over the 

last 2 years), and companies will hesitate to go public costing untold jobs. 

I’d like to start with a proposal for some concrete steps that regulators can take 

to address much of the instability and unfairness in capital markets: 

1. Unify trading rules, regardless of venue—exchange, ATS, ECN and dark pools 

should all abide by the same general rules. Require substantial price improvement to internalize flow. This means more than $0.001. 

2. To receive a rebate from any venue on which securities are transacted, a market participant must be a genuine registered ‘‘market maker’’ subject to affirmative market making obligations. All such rebates or other compensation must 

be disclosed. 

3. Mandate a unique identifier for every supervisory individual. This ID would 

have to be attached to every quote submitted to any venue, and provide a 

38 

23 Bessembinder, Hendrik (Hank), Hao, Jia, and Lemmon, Michael L.,‘‘ Why Designate Market Makers? Affirmative Obligations and Market Quality’’ (June 2011). Available at SSRN: 

http://ssrn.com/abstract=989061. 

mechanism for regulators to associate quotes with the supervisory individual 

on the trading desk. 

4. Eliminate pay-for-order-flow practices. 

5. Establish strong, clear market technology standards and regularly audit firms 

to ensure they are being followed. 

6. Revoke order type approval for order types that do not have a clearly demonstrated utility to long-term investors and market stability. 

It cannot be legitimately denied that the fragmentation of the equity market has 

added unnecessary complexity and created structural inefficiencies. A change of 

mentality is required from a regulatory point-of-view: from the view that there are 

market centers to be regulated to the view that there is a marketplace to be regulated, independent of individual market centers. Reg NMS (National Market System) was a first step down this path, but the mentality must be embraced at every 

level. 

Rules and regulations should apply to all actors and all venues where security 

transactions are taking place. All of the ideas referred to here are guided by this 

principle. In addition, much greater coordination and visibility must be achieved 

across asset classes. HFT firms trade equities, futures, FX and treasuries without 

blinking. It’s near impossible to regulate the industry without a cross asset-class 

viewpoint. 

As mentioned before, the maker-taker business model leads to skewed incentives 

for exchanges and ‘‘good times’’ for liquidity providers. A simple change could have 

a dramatic impact on the quality of liquidity in the market and the level of volatility: any venue that offers any type of rebate for liquidity provision should be required to tie that rebate to affirmative market-making obligations. According to a 

review by Charitou and Panayides (2006), many markets around the world have embraced a form of this model, including the Toronto Stock Exchange, the London 

Stock Exchange, the Deutsche Bourse, Euronext, and the main stock markets of 

Sweden, Spain, Italy, Greece, Denmark, Austria, Finland, Norway, and Switzerland. 

All of them designate market makers with affirmative obligations to supply liquidity 

for at least some stocks. The London Stock Exchange requires market makers to 

register and to maintain quotes within a maximum spread band, and with minimum 

size. 

Another study by Bessembinder, Hao, and Lemmon (2011) concluded the following 

about the maximum spread model: 23

• A maximum spread rule will lead to a narrowing of bid-ask spreads, not a widening, and that will lead ‘‘to increased trading, which can improve allocative efficiency in the presence of information-based externalities.’’ 

• This type of rule ‘‘can improve social welfare’’ as long as the ‘‘spread is not constrained to be less than the real friction, i.e., the social cost of completing 

trades.’’ 

• Such a rule can also increase the speed of price discovery by encouraging more 

trading by both informed and uninformed traders. 

• Most importantly, they show that ‘‘future flash crashes can be potentially avoided, and economic efficiency enhanced, by agreements calling for one or more 

designated market makers to continue to provide liquidity during periods of enhanced information asymmetries. While the DMMs would need to be compensated for their losses suffered at such times, the social gains from trade 

would exceed the costs.’’ 

There is no doubt that many if not all of these ideas are controversial. However, 

historically ideas such as these have not been so controversial. It’s not clear what 

mechanism can be used to compensate DMMs for losses during severe events. It 

should be clear that it is in the public interest to have DMMs provide liquidity during high-stress events, so it is worth thinking creatively about whether the public 

or individual exchanges can help to backstop liquidity providers during these events. 

There is no doubt, however, that liquidity providers are making substantial profits, 

but without affirmative obligations to maintain markets they are shifting much of 

the risk to the public. If the market is truly a public good then it is incumbent on 

regulators to ensure that it remains stable, fair and orderly, rather than ensuring 

that exchanges continue to profit from the maker-taker model. 

39 

The SEC should also maintain a database of supervisory individuals and assign 

a unique identifier to each of them. Any venue that accepts incoming orders can 

mandate the inclusion of another field that would contain the unique ID of the supervisory individual. While this information would not be propagated publicly, it 

would be available to exchange surveillance teams and to regulators. This would 

have a two-pronged effect. It would allow rapid identification of individuals responsible for aberrant order flow, and provide the ability to quickly contact them and 

find out what is happening. In addition, it would remove the cloak of anonymity 

that participants currently enjoy, and thereby act as a deterrent to predatory behavior such as quote stuffing, stop-hunts and other manipulative behavior. The technological effort to implement this is not trivial, but it is not complex either. As someone who has worked with these applications, protocols and connections for nearly 

a decade, I can tell you that it could be implemented in a month or less if so mandated. 

The practice of selling retail order flow, what is commonly referred to as Pay-ForOrder-Flow, should be ended. It exacerbates the problem of adverse selection discussed earlier, and removes natural buyers and sellers from the market. It is having 

a negative impact on market quality, with no benefit other than to the firms selling 

their order flow and to those firms able to pick out the lucrative orders before sending the toxic ones to market. 

Finally, the bar for order type approval should be raised to be similar to any regulatory or rule change. The SEC demands evidence that any changes benefit the market, and should do the same with exotic order types. As Scott Patterson demonstrates in his book, Dark Pools, these order types are having a poorly understood 

impact on markets and long-term investors. Many order type approvals should be 

revoked, and the burden of proof placed on the exchange to demonstrate their social 

utility. 

Additionally, I believe the SEC should consider some more creative, novel ideas 

for limited implementations or pilots to assess their efficacy and actual impact on 

the market. These ideas include: 

• A 50ms minimum quote life/time-in-force 

• Open up access to historical and current market data, and incentivize programmers to help design better tools for regulators. 

• Greatly increase the SEC’s technology capabilities. This means a substantial investment in technology and personnel, and creative thinking about market-wide 

surveillance. 

The SEC should consider a 50ms minimum quote life, at least on a pilot basis, 

to observe what the actual impact would be. With so much evidence against the utility of ‘‘fleeting orders’’ it is at least worth considering. This is the type of effort that 

could be rolled out quickly on a preliminary basis, in order to examine what the 

impact actually is. Not only would removing those orders help reduce the technology 

burden to firms to participate in markets, but the requirement to stand by a quote, 

at least for one-sixth of the time it takes to blink an eye, could help to change some 

of the behavior of HFT strategies. Claims that this would widen spreads are unsubstantiated, and must not be accepted until proven in a pilot program. One reasonable concern is the cross-asset nature of securities, and therefore in a broader rollout, such a program should be considered within a cross-asset perspective and effort. 

Finally, a dramatic change in how market data and surveillance are viewed 

should be considered. The Internet and Open Source efforts have taught us that 

open systems are nearly always preferable to closed. In that spirit, and under the 

premise that markets are a public good, market data feeds and tick data history 

should be opened up. It is critical to understand that many academic papers are 

skewed because they are either funded directly by the industry, or provided access 

to expensive and proprietary data by the industry. Opening up access to this data 

would have a dramatic effect. 

Access to the historical data of direct market data feeds should be made available 

freely to the public, and a prize-based incentive created for those who can find innovative ways of designing surveillance systems and algorithms. While the exchanges 

will surely argue vigorously against this idea as market data is a major profit engine for them, it is in the public’s interest for the regulation and enforcement to 

move out of the 20th century. 

The SEC should also consider implementing a market-wide surveillance mechanism. In this new interconnected market, individual surveillance groups at market 

centers are not sufficient. The SEC must build sophisticated surveillance capabilities. They have taken a first step, although unfortunately a very inexplicable one. 

40 

1T. Rowe Price Associates, Inc., a wholly owned subsidiary of T. Rowe Price Group, Inc., together with its advisory affiliates (collectively, ‘‘T. Rowe Price’’), had $541.7 billion of assets 

under management as of June 30, 2012. T. Rowe Price has a diverse, global client base, including institutional separate accounts; 

T. Rowe Price sponsored and sub-advised mutual funds, and high net worth individuals. The 

T. Rowe Price group of advisers includes T. Rowe Price Associates, Inc., T. Rowe Price International Ltd, T. Rowe Price Hong Kong Limited, T. Rowe Price Singapore Ltd., T. Rowe Price 

(Canada), Inc., and T. Rowe Price Advisory Services, Inc. 

They have contracted with a prominent HFT firm to build a ticker plant, the first 

step towards processing and storing market-wide tick data. This is reminiscent of 

the fox guarding the hen house. This HFT firm is not in the business of building 

ticker plants. They are in the business of making money trading. They would not 

have taken this on if they did not believe it was in the long-term best interests of 

their trading profit center. 

In addition, there are a multitude of vendors who do this all day everyday—why 

one of them was not chosen for this contract is inexplicable. The SEC should consider canceling the contract with the HFT firm or just contract with a technology 

vendor, just as any other firm would. The SEC should also hire quantitative researchers, and compensate them as close as possible to industry rates, along with 

bonuses based on a percentage of the fines that they are able to uncover through 

data analysis. The SEC needs to attract top-line talent, and to do so they must be 

able to compensate competitively. This is an arms race that Wall Street is winning 

easily right now. While the SEC has obvious budgetary constraints, they can get 

creative about bonuses, potentially offering percent of fines, similar to their whistleblower program. 

The quantitative data analysis will be made much more robust with the unique 

identifiers associated with supervisory individuals mentioned earlier. The SEC 

should work very closely with individual surveillance teams at the exchanges, 

leveraging best-of-breed ideas, and helping those that are behind to catch-up. A 

market-wide surveillance system could eventually be expanded into a robust set of 

technology standards, tripwires/speed bumps, and other mechanisms for quickly detecting aberrant or nefarious behavior and immediately throttling or cutting off the 

offending firm’s market access. 

Many of the ideas referenced here are not popular within the HFT industry. 

Whenever an idea is proposed that they do not agree with, they respond that there 

is no way they can operate under such rules, they will go out of business, spreads 

will blow out, the market will cease to function, and generally the sky will come 

crashing down and life will end as we know it. I have worked with these folks for 

years now, and I must have a much higher opinion of their capabilities than they 

do. These are some of the smartest people in the world, and they will figure out 

how to continue to make money, and compete, albeit on a more level playing field. 

Some will go out of business, as is the nature of capitalism, and some will thrive. 

In the end our markets will be much more stable, resilient and effective price discovery and capital formation mechanisms, and confidence will be restored to the retail and institutional investors. 

PREPARED STATEMENT OF ANDREW BROOKS 

HEAD OF U.S. EQUITY TRADING, T. ROWE PRICE

SEPTEMBER 20, 2012 

Introduction 

Chairman Reed, Ranking Member Crapo, and distinguished Members of the Senate Subcommittee on Securities, Insurance, and Investment, thank you for the opportunity to testify today on behalf of T. Rowe Price 1 regarding the effects of recent 

significant changes in trading technology and practices on market stability. My 

name is Andrew (Andy) M. Brooks. I am Vice President and Head of U.S. Equity 

Trading of T. Rowe Price Associates, Inc. I joined the firm in 1980 as an equity trader and assumed my current role in 1992. This is my 33rd year on the T. Rowe Price 

trading desk. 

T. Rowe Price is celebrating its 75th year of advising clients. We are a Baltimorebased global adviser with over $540 billion in assets under management as of June 

30th, 2012, and more than 3 million client accounts. We serve both institutional and 

individual investors. 

We welcome the opportunity for discussion regarding the industry and market 

practices. 

41 

Our firm is particularly focused on the interests of long-term investors. We appreciate the role other types of investors can have in creating a dynamic marketplace. 

However, as we talk with our clients, there is a growing distrust of the casino-like 

environment that the marketplace has developed over the past decade. We worry 

that the erosion of investor confidence can undermine our capital markets, which 

are so important to the economy, job growth, and global competitiveness. Reaffirming a strongly rooted commitment to fairness and stability of the market’s infrastructure is critically important. 

Over the past two decades the markets have benefited from innovation from new 

technology and competition. Generally, markets open on time, close on time, and 

trades settle. However, there are problems below the surface. 

Here are some things we find concerning: 

Order Routing Practices 

We question the nature of various order routing practices. The maker-taker 

model, payment for order flow, and internalization of orders all seem to present a 

challenge to order-routing protocols. Are order routing practices and incentives an 

impediment to the overarching requirement to seek best execution on all trades? 

Colocation/Market Data Arbitrage 

We believe that the widespread use of colocation creates an uneven playing field 

that favors those who can and will pay for it. We question whether this has produced a market that values speed over fair access. In no other regulated industry 

is one party allowed a head start in exchange for payment. Our understanding is 

that current colocation practices allow for a market-data arbitrage where some investors get quotations and trade data faster than others. This advantage is traded 

upon, causing some participants to believe they are victims of front-running or are 

at least disadvantaged. 

Speed and Impact on Market Integrity 

Our sense is that the almost myopic quest for speed has threatened the very market itself. It also seems many high frequency trading (HFT) strategies are designed 

to initiate an order to simply gauge the market’s reaction and then quickly react 

and transact faster than other investors can. This seems inherently wrong. Our understanding is that the continued push for speed is not producing any marginal benefit to investors and in fact may be detrimental. This pursuit of speed as a priority 

is in direct conflict with the pursuit of market integrity as a priority. 

Inaccessible Quotes and High Cancellation Rates 

The growth of HFT has lead to increased volume; however, whether the corresponding volume is ‘‘good’’ or ‘‘bad’’ deserves analysis. Volume does not necessarily 

mean liquidity for large institutional investors. When you combine high HFT volumes and even higher cancellation rates, these forces can combine to undermine 

market integrity and cause deterioration in the quality and depth of the order book. 

We feel that this volume is transitory and misleading. 

Challenges to the National Market System (Regulation NMS) 

We believe the original construct of Regulation NMS was laudable and designed 

to encourage competition. However, we do not believe this regulation contemplated 

today’s highly fragmented marketplace, where we have 13 different exchanges and 

over 50 unregulated ‘‘dark pools.’’ In such a fragmented market, can one really be 

confident in achieving best execution given the explosion of market data traffic? We 

question the markets’ ability to process the overload of market data. 

Conflicts of Interest 

We question whether the functional roles of an exchange and a broker-dealer have 

become blurred over the years and could warrant regulatory guidance regarding the 

inherent conflicts of interest. It seems clear that since the Exchanges have migrated 

to ‘‘for-profit’’ entities, a conflict has arisen between seeking volume to grow revenues and their obligation to assure an orderly marketplace for all investors. 

HFT Trading Strategies 

Professional and proprietary traders often have divergent interests from those of 

investors concerned about the long-term. When the average holding period for such 

traders is measured in seconds as opposed to months or years, have we destabilized 

the market. Given recent market volatility, more study is warranted to assess the 

impact of the exponential growth of short-term trading strategies. Most rules and 

regulations seem to further enable those with short term profit incentives as evidenced by the proliferation of new order types suggested by exchanges and approved 

by regulators. 

42 

Suggestions 

We believe it is time is to step back and examine market structure and how it 

impacts all investors. A good first step might be to experiment with a number of 

pilot programs to examine different structural and rule modifications. We suggest 

a look at the appropriateness of colocation as a general practice and enhanced oversight of high frequency trading and other strategies that might be unduly burdensome to overall market functionality. We would like to see a pilot program where 

all payments for order flow, maker-taker fees, and other inducements for order flow 

routing are eliminated. We envision a pilot where there are wider minimum spreads 

and mandated time for quotes to be displayed to render them truly accessible. These 

programs can include a spectrum of stocks across market caps and average trading 

volumes, among other factors. We also suggest a pilot program of imposing cancellation fees for unacceptable trade to cancellation ratios. A key question is should we 

foster consolidation in this fragmented market? At a minimum, should we raise the 

barrier for becoming an exchange? In our opinion, requiring a more robust testing 

for new software would seem to make sense. 

Conclusion 

T. Rowe Price appreciates all the efforts of the SEC and Congress as we strive 

to make the markets better and fairer for all participants. The Consolidated Audit 

Trail, Large Trader ID, limit up/down initiatives are all improvements. We suggest 

any regulatory proposals be aligned with a goal of making the markets simpler, 

more transparent, and less focused on speed. We applaud the Committee’s interest 

in making sure the right questions are asked. 

There are currently over 1,000 order types to express your buy and sell interest 

and we suggest that a simplified model may be more efficient for all investors. The 

issues we face are enormously complex. We certainly do not have all the answers. 

We believe that it is time to revisit the historical responsibility to provide a fair and 

orderly market. 

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PREPARED STATEMENT OF CHRIS CONCANNON 

PARTNER AND EXECUTIVE VICE PRESIDENT, VIRTU FINANCIAL, LLC 

SEPTEMBER 20, 2012 

Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee, I 

want to thank you for the opportunity to appear before you today. My name is Chris 

Concannon and I am an Executive Vice President for Virtu Financial, LLC. 

Virtu Financial (‘‘Virtu’’ or the ‘‘Company’’) is a global electronic market maker. 

Virtu is an active market maker on more than 100 markets around the globe. Virtu 

makes markets from our six offices in New York, Los Angeles, London, Dublin, Sydney, and Singapore. The Company’s market making activity spans across multiple 

asset classes, including cash equities, fixed income, currencies, futures, options, energy products, metals and other commodities. Virtu, through its subsidiaries, is directly registered as a broker dealer or investment firm and operates as a registered 

market maker on most primary markets around the globe. In the U.S., Virtu operates two registered broker dealers that are also registered as market makers or designated market makers on the NYSE, Nasdaq, BATS Exchange, NYSE Arca, and 

NYSE MKT. In Europe, Virtu operates a registered investment firm that is also registered as a market maker on the London Stock Exchange, the Swiss Exchange, 

Euronext, and the Deutsche Bourse Exchange. Obviously, Virtu believes in the benefits of market making and is committed to providing continuous, obligated liquidity 

in the markets we serve. 

In discussing the state of the U.S. equity market, I start from the premise that 

our equity market is the most dynamic and efficient market in the world. The U.S. 

equity market is a special asset that should be celebrated. Our markets are envied 

by Nations and financial centers around the globe. Our U.S. equity market is also 

the most liquid and robust pricing mechanism on the planet. My firm trades across 

all of the major financial markets and no market can compare to the U.S. equity 

market in terms of pricing efficiency and liquidity. Companies listed on our U.S. 

markets enjoy the most efficient and liquid market which contributes to higher returns for their investors. Over the last 4 years, I have witnessed an unprecedented 

number of claims that our markets are horribly broken, unfair and dangerous. 

These claims tend to be short on facts and evidence, but long on press coverage and 

book deals. Our market is not perfect. And it has recently experienced some dramatic mishaps. But, despite its flaws, it is a market that has withstood the most 

unprecedented volatility and repricing of equity values in our lifetime while maintaining the same levels of pricing efficiency. 

Let me be clear, our market is not perfect. It has flaws and unnecessary complexity. The U.S. equity market is overly fragmented and, likely, over engineered. 

Stocks in the U.S. trade electronically on 13 national securities exchanges and over 

40 dark pools. The current state of our equity market is not one that we would set 

out to design if we did it all over again. The U.S. equity markets began evolving 

into a fully electronic market during the 1990s. For the last decade, our markets 

have been largely automated. That means every exchange and every market in the 

U.S. is a fully automated, electronic destination. Virtually every order arrives at its 

intended exchange in electronic form. The automation that exists in our market 

today is not a new phenomenon. Technology has been operating our markets for the 

last 15 years. 

With fragmentation and technology comes complexity. Our market is one of the 

most complex securities markets on the planet. It is not naturally complex. It is 

complex because of the number of major regulatory reengineering events that have 

taken place in the U.S. over the last 15 years. For example, the list of major market 

structure rule changes includes the Limit Order Display Rule, Regulation ATS, 

Decimalization, T+3 Settlement Cycle, Regulation NMS, Regulation SHO, Single 

Stock Circuit Breakers and, more recently, the Market Access Rule. Each of these 

major regulatory reengineering events required substantial technological enhancements to be delivered by all industry participants and exchanges. These were not 

simple software programming endeavors. These were all major technology projects 

completed across the industry. 

I would like to focus on three areas that I believe deserve further review: (1) our 

choice of a single market structure for all listed companies; (2) our markets failure 

to enhance market maker obligations; and (3) the industry’s current risk management standards. 

First, our market is currently designed as a ‘‘One-Size-Fits-All’’ market. What I 

mean by this is that most of our major market structure rules do not distinguish 

between the size or market capitalization of the listed company, or the trading characteristic of its stock. Our markets are designed to execute all stocks, regardless of 

47 

shape or size, using the same market mechanism. As the list of public companies 

continues to grow, a more diverse number of public companies trade on our market 

while subject to the same market structure. A stock that trades once per day is traded in the same market structure as a stock that trades one million times per day. 

Our market is solely designed for Cisco, Microsoft, and Bank of America and not 

for a stock that trades by appointment. I believe we should revisit our current market structure in order to create a better pricing mechanism for all stocks of different 

shapes and sizes. This One-Size-Fits-All approach is further exacerbated by an expansion of the portfolios of our largest investors. As institutional holdings expand 

further into less liquid stocks, like Russell 2000 stocks, our largest institutions are 

struggling to trade in our poorly designed market structure for those types of stocks. 

My second area of focus is on our markets’ failure to enhance market making obligations. While my firm is a market maker and it is easier for me to call for enhanced market making obligations, I fundamentally believe that we need to increase 

obligated liquidity in our markets. Flash crashes, miniflash crashes and other market disruptions demonstrate the need for additional obligated liquidity in our market. However, I believe enhanced market maker obligations should be targeted 

where they are most needed and that is in our less liquid stocks. And so, my earlier 

point about our flawed, single market structure should be considered with enhanced 

market making obligations as a component of a new market model. New market 

models for less liquid stocks should be accompanied with enhanced market maker 

obligations. 

My final area of focus is the industry’s current risk management standards. In 

light of recent events, I believe that the industry should explore ways to improve 

risk management standards. Industry participants have already identified several 

areas of risk management enhancements that should be implemented and could be 

delivered in short order. First, pretrade risk management limits are already required by the Securities and Exchange Commission (SEC) under SEC Rule 15c3-5 

(also known as the ‘‘Market Access Rule’’). Under the Market Access Rule, which 

has been in effect for over a year, firms are required to establish pretrade credit 

limits for every customer account and for the firm’s own proprietary account. The 

credit limits required by the Market Access Rule must be administered in real-time 

and at all times. These credit limits are a firm’s primary defense against unwanted 

trading activity by the firm or by its client. 

In addition, the industry is currently exploring specialized ‘‘Kill switches’’ that 

would be administered by exchanges. These ‘‘Kill switches’’, as currently being discussed, would provide a systematic shut-off of a firm if it exceeded prescribed or preset trading limits. ‘‘Kill switches’’ would not be a primary defense, but rather, a secondary defense to back stop the failure of other risk management measures operated by a firm. Kill switches have operated effectively on futures exchanges in the 

U.S. for many years. These same trading limits could be implemented across all 

U.S. equity exchanges. Like the futures exchange limits, firms would be required 

to establish limits on each equity exchange. Such a kill switch would have severely 

limited the damage done on August 1st of this year. 

The last component to enhanced risk management is one of the most important. 

We believe a simple feature referred to in the industry as ‘‘drop copies’’ should be 

required as a mandatory risk management tool. ‘‘Drop copies’’ are separate and distinct connections offered by exchanges and other markets. Drop copies, which are 

widely used by the industry, provide a real-time echo, or copy, of a firm’s trading 

activity on a given exchange. Drop copies are primarily used by the industry to run 

reconciliations that compare a firm’s known trading activity against what the exchange believes was traded by the firm. This is commonly referred to as a ‘‘Street 

vs. House’’ comparison. If such a drop copy comparison is conducted in real-time by 

systems that are independent from the firm’s trading system, a firm will always 

have an accurate assessment of its positions and trading activity, including both intended and unintended activity (See, Exhibit I). 

While I believe firms should have a robust process for developing and testing new 

software, the industry must have advanced risk management systems to limit the 

risk of unintended trading activity by a firm or its client. We know with certainty 

that software has bugs, hardware crashes and networks go down no matter the 

robustness of a firm’s development and infrastructure process. The industry must 

build risk protections that assume the worst while a robust development and testing 

process avoids the worst. Pretrade risk checks, ‘‘Kill switches’’ and real-time drop 

copies protect us from the worst events. 

Thank you again for the opportunity to be here today to speak on this subject. 

I would be pleased to answer the Committee’s questions. 

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PREPARED STATEMENT OF LARRY TABB 

FOUNDER AND CHIEF EXECUTIVE OFFICER, TABB GROUP

SEPTEMBER 20, 2012 

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RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM DAVID LAUER 

Q.1. Germany is considering legislation that would impose new 

rules on high-frequency trading. It is my understanding that this 

legislation would require traders to register with Germany’s Federal Financial Supervisory Authority, collect fees from those who 

use high-speed trading systems excessively, and limit the number 

of orders that may be placed without a corresponding trade. The 

new rules would also grant the regulator the power to compel firms 

to detail their trading practices. 

Similar European-wide legislation is being considered by the 

Committee on Economic and Monetary Affairs of the European 

Parliament. These measures include a requirement for orders to 

rest on the exchange order book for a minimum of half a second 

and the testing of algorithms that allow preprogrammed trading. 

Canada began increasing the fees charged to firms that flood the 

market with orders earlier this year, with firms charged for all the 

orders they cancel, not just the trades they execute. Additional 

rules are expected to cut the amount of trades going to dark pools. 

Starting in October, the pools will be allowed to take orders only 

if they offer a significantly better price than the public exchange. 

What is your view of these various reform proposals? Would 

these measures make the U.S. markets more of less fair and efficient? Would these measures be feasible in the U.S. markets? Why 

or why not? 

A.1. Adoption of several of these reforms would help make U.S. 

markets more fair and efficient. All of them are feasible, but that 

does not mean that they are advisable. 

I think many of the reform proposals are commonsense ideas 

with substantial empirical support. Requiring traders to register is 

an excellent idea and one that I continue to advocate for. This is 

part of the idea I presented in my written testimony requiring 

firms to register trading strategies and tag all of their orders with 

a strategy-level ID. This would deter nefarious activity and help 

regulators enforce existing regulations. 

I presented studies in my written testimony that attempt to 

quantify the negative externalities that HFT generate. Part of that 

is from excessive order rates and order cancellation rates. At the 

moment the cost of these externalities is not being borne by the 

producers. Germany and Canada’s move to change that dynamic 

with cancellation fees is laudable. 

Finally, the Canadian rules are exactly the type of rules I argued 

for in my written testimony. Increasing the requirements for off-exchange execution is critical to restoring natural liquidity in the lit 

markets. These requirements should include substantial price improvement and a minimum execution size. 

I would not advocate for the European-wide legislation. I do not 

believe a Financial Transaction Tax would have the intended consequences. We have seen dramatic evidence of fleeing liquidity in 

those markets that have adopted this tax, although the market 

quality implications of that flight are still under study and may not 

be as dire as the liquidity flight would appear. A minimum resting 

period of a half second also seems extreme and not supported by 

empirical evidence. I have advocated for a pilot program to test a 

73 

50 millisecond holding period based on academic studies. I now believe that such a policy would only be advisable if it were done 

across all affected asset classes, include equities, options, and futures. 

Q.2. In discussing the use of a ‘‘hide not slide’’ order type, there 

was testimony that stated that such an order is mainly used by 

professional traders and that it is not permitted for a broker to 

take an investor’s order and slide it. Can anyone other than a professional trader use this order type? For example, can a brokerdealer acting on behalf of institutional investors use a ‘‘hide not 

slide’’ order? Why or why not? 

A.2. Anyone can use this order type who has a direct connection 

to an exchange, and control over the flags that they are setting in 

the order that is sent to the exchange. A broker-dealer can use this 

order type, although generally they only use the simplest order 

types when sending out orders on behalf of investors (or rebatemaximizing order types). Customers would have to specifically request that this order type is used, and ordinarily they would not 

do that. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN 

FROM DAVID LAUER 

Q.1. High-speed trading is an issue that has received considerable 

attention from market regulators throughout the world. 

On September 26, 2012, German Chancellor Angella Merkel’s 

cabinet approved draft rules that would require high-speed traders 

to register with securities regulators and would mandate that automated orders be labeled as such when submitted to regulators. Can 

you evaluate the strengths and weaknesses of the approach taken 

by Germany? 

A.1. As covered in my written testimony, I believe that registration 

of High-Frequency Traders is a simple, critical first step to regulating their activities. I also believe that the German proposal does 

not go far enough, as I would like to see registration of individual 

trading strategies with unique ID’s assigned to them. These ID’s 

should be placed in every order sent by these traders for regulatory 

tracking purposes, and also to support the function of enhanced, 

adaptive kill switches. 

Q.2. In August, the Australian Securities & Investment Commission (ASIC) proposed reforms to automated share trading that are 

intended to prevent market disruptions. The proposal would require high-speed traders to put in place pretrade ‘‘filters’’ and to 

limit or suspend automated orders that would ‘‘interfere with the 

efficiency and integrity of the market.’’ This mandate is coupled 

with a fine on traders that could not trace orders and trading messages. Can you evaluate the strengths and weaknesses of the approach taken by Australia? 

A.2. I believe it is important to unify risk controls across the industry, and Australia’s efforts here are a good first step. What they are 

lacking is a centralized means of enforcing these regulations on a 

real-time basis, instead relying on analysis and fines after-the fact. 

In the U.S. most individual firms already have some risk controls 

74 

in place, but regulators can do a better job of following Australia’s 

example and unify these requirements. I don’t believe that static 

kill switches are the answer however, and I don’t believe that individual market centers should have this responsibility. Market activity cannot be analyzed by individual market centers, and therefore a centralized approach is necessary. The SEC can take on this 

role on a real-time basis, provided these firms are registered and 

tagging their orders with unique ID’s. 

Q.3. In July, Hong Kong’s Securities and Futures Commission 

(SFC) released a proposal targeting automated trading. The SFC’s 

proposal would require intermediaries to have ‘‘appropriate policies, procedures and controls . . . when they conduct electronic 

trading,’’ example include pretrade risk management controls and 

post-trade monitoring. Can you evaluate the strengths and weaknesses of the approach taken by Hong Kong? 

A.3. I believe Hong Kong’s proposal suffers from the same weaknesses as Australia’s. Individual firms can have an inordinate impact on the market, and therefore fining firms after-the-fact will 

not help to protect the market during a stressful event. 

Q.4. Given that a wide range of countries have pursued changes 

that address computerized trading, how will the competitiveness of 

U.S. financial markets be impacted by a failure to adopt similar reforms? 

A.4. The U.S. markets are developing a poor reputation because of 

our failure to properly regulate HFT. While some of the international reforms are knee-jerk reactions, and therefore inadvisable, 

many of them are sensible and will help to restore trust. These include registration of HFT firms, attempts to quantify negative 

externalities and shift the cost of those to the producer via cancellation fees, and increasing the hurdle for off-exchange executions. 

Q.5. In an October, the Federal Reserve Bank of Chicago released 

a letter titled ‘‘How to keep markets safe in the era of high-speed 

trading.’’ The letter outlines several risk controls that could improve market structure and investor confidence. Please discuss the 

costs and benefits of the following controls: 

Intraday position limits. 

A.5. This is a reasonable control, and is one most firms have already implemented. 

Q.6. Limits on the number of orders that can be sent to an exchange within specified period of time. 

A.6. This has similar problems to static kill switches. While it 

seems like a reasonable approach for a normally operating market, 

during times of market stress this could lead to severe problems. 

Q.7. Automated trading is a logical extension of technology in a 

competitive market that may provide benefits such as increased 

transparency and better execution for market participants. What 

would happen to price discovery, transparency, and execution 

prices if high-speed trading ceased or declined? 

A.7. It is important to distinguish between technology advances 

and high-frequency trading. Generally, most of the benefits to inVerDate Nov 24 2008 15:33 Apr 26, 2013 Jkt 048080 PO 00000 Frm 00078 Fmt 6602 Sfmt 6602 L:\HEARINGS 2012\09-20 COMPUTERIZED TRADING -- WHAT SHOULD THE RULES OF T
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vestors of increased liquidity and tighter spreads came before 2007 

and the advent of high-frequency trading. In fact, several studies 

have shown increased spreads over the last couple of years, and no 

comprehensive studies have been done on execution costs overall. 

Spreads can be a poor proxy for execution costs, as so much liquidity in the market is fleeting (up to 40 percent according to one 

study cited in my written testimony). That being said, it is clear 

that in the near-term, market quality, price discovery and execution prices would all be harmed if high-speed trading were to cease, 

as it has become the primary supplier of liquidity in the market. 

We should instead take a measured approach to reducing nefarious 

activity, reining in certain practices, and evening the playing field. 

Many of the recommendations I make in my written testimony 

would be incremental approaches to confronting these issues, rather than blunt instruments such as a transaction tax. 

Q.8. In the United States the Minimum Price Variation (MPV) for 

all stocks over one dollar is one penny. In Europe MPVs are less 

uniform. 

How do MPVs impact high-speed trading? 

A.8. They have little impact on high-speed trading. Computers are 

very good at adjusting to this type of variable. They do help to reduce competition to high-speed traders, as smaller MPV’s in lowpriced or less liquid stock make it less profitable for regular market 

makers to provide liquidity. The reason is that when a market 

maker offers stock in a less liquid name, with an MPV of $0.01, 

a high-speed trader can simply step in front of them. While this 

may mean the appearance of a tighter spread, as market makers 

are driven out of business, spreads in these names widen again, 

and market depth suffers. 

Q.9. What factors should be considered when determining the appropriate MPV? 

A.9. An interesting proposal is to simply allow a firm to choose its 

own MPV, under the advice of an investment bank or other fiduciary. Barring this free market approach, market capitalization and 

liquidity should be the main factors. 

Q.10. Should there be different MPV’s for stocks of varying price 

or trading volume? 

A.10. I agree that a one-size-fits-all approach to MPV has harmed 

smaller capitalization and less liquid companies. Alternatives 

should be explored and a pilot program would be an excellent first 

step. 

Q.11. Several witnesses mentioned the proliferation of order types 

that are designed for high-speed traders. 

How do the order types available to trades in the United States 

compare to those available in markets abroad? 

A.11. Foreign markets have a much smaller set of order types. 

Many order types are a result of Reg NMS requirements, and 

therefore other markets do not require such an extravagant set. 

Q.12. How do exotic order types advantage or disadvantage retail 

investors, institutional investors, exchanges, and high-speed traders? 

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A.12. High-frequency traders thrive on complexity. They make it 

their business to understand the nuances of every order type, and 

the exchanges often cater to them by providing access to the developers of the logic, or consulting with them when creating a new 

order type. HFT firms use exotic order types to segment order flow 

so that they don’t interact with certain types of traders, or to play 

tricks to jump the queue. In addition, a lack of sophistication by 

institutional investors means that they can end up using order 

types that disadvantage them in terms of cost or priority. 

Q.13. Please list those order types that you believe could be eliminated without doing harm to markets. 

A.13. Post-only, PNP, PL Select, Hide-Not-Slide and the retail price 

improvement orders that have recently been approved. 

Q.14. The increased fragmentation of exchanges and dark pools 

complicates the task of developing a market wide approach to data 

aggregation and analysis by regulators. 

What type of technology investments could advance the ability of 

the Securities and Exchange Commission and the Commodity Futures Trading Commission to better monitor markets and develop 

a market wide approach to data? 

A.14. I have developed and presented a full proposal in my written 

testimony for a real-time, cross-asset monitoring system. This 

strikes me as the bare minimum that the regulators need to understand and stay on top of the current market. The Consolidated 

Audit Trail is important, but will fall far short of what is needed 

on a real-time basis. Markets are moving too quickly for regulators 

to always be a day or more behind. Regulators can take a balanced 

approach, including some investments in technology and leveraging 

the existing investments exchanges have already made. This realtime, market-wide surveillance system combined with a firm-level 

or strategy-level registration system would allow regulators to finally do their job, and enforce existing regulations properly. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM CHRIS CONCANNON 

Q.1. Germany is considering legislation that would impose new 

rules on high-frequency trading. It is my understanding that this 

legislation would require traders to register with Germany’s Federal Financial Supervisory Authority, collect fees from those who 

use high speed trading systems excessively and limit the number 

of orders that may be placed without a corresponding trade. The 

new rules would also grant the regulator the power to compel firms 

to detail their trading practices. 

Similar European-wide legislation is being considered by the 

Committee on Economic and Monetary Affairs of the European 

Parliament. These measures include a requirement for orders to 

rest on the exchange order book for a minimum of half a second 

and the testing of algorithms that allow preprogrammed trading. 

Canada began increasing the fees charged to firms that flood the 

market with orders earlier this year, with firms charged for all the 

orders they cancel, not just the trades they execute. Additional 

rules are expected to cut the amount of trades going to dark pools. 

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Starting in October, the pools will be allowed to take orders only 

if they offer a significantly better price than the public exchange. 

What is your view of these various reform proposals? Would 

these measures make the U.S. markets more or less fair and efficient? Would these measures be feasible in the U.S. markets? Why 

or why not? 

A.1. Virtu Financial, LLC, (Virtu) is a global electronic market 

maker and active in more than 150 markets around the world. 

Virtu actively is actively engaged in dialogues with regulators 

around the Globe. Virtu actively supports global market reforms 

that include: 

1. Registration requirements for active trading firms; 

2. The ban on ‘‘Naked-sponsored’’ access; 

3. Increased capital standards for market makers; 

4. Implementation of market access and risk controls; 

5. The establishment of real-time credit limits; 

6. Limit-up/Limit-down Trading Controls; 

7. The establishment of exchange kill switches; 

8. Modernization of the U.S. surveillance systems and mechanism; and 

9. Enhanced market making obligations. 

However, rules or restrictions which limit technology or alter 

micromarket structure should be studied and have a measurable 

benefit. Our current market complexity was the result of micromarket structure changes implemented over the last 15 years. 

Those changes were not adequately studied and were driven by 

other initiatives. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN 

FROM CHRIS CONCANNON 

Q.1. Automated trading is a logical extension of technology in a 

competitive market that may provide benefits such as increased 

transparency and better execution for market participants. What 

would happen to price discovery, transparency, and execution 

prices if high-speed trading ceased or declined? 

A.1. Our markets converted to automated markets 15 years ago. 

Since that conversion was made, trading costs of declined materially for all investors large and small. During this evolutionary 

change that benefited investors, our market intermediaries had to 

change as well. Our markets’ market makers are automated out of 

the need to survive in an automated world. The elimination or decline of our electronic liquidity providers would directly impact 

price discovery and execution quality. Investors would ultimately 

be harmed by introducing unnecessary frictions into our markets. 

Q.2. Several witnesses mentioned the proliferation of order types 

that are designed for high-speed traders. How do the order types 

available to traders in the United States compare to those available 

in markets abroad? 

A.2. The implementation of regulatory changes over the last 15 

years, such as Regulation ATS and Regulation NMS, has resulting 

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in greater market fragmentation and increased market complexity. 

It is this unique fragmentation and market complexity that has resulted in the proliferation of order types in the United States. 

Q.3. In the United States the Minimum Price Variation (MPV) for 

all stocks over one dollar is one penny. In Europe MPVs are less 

uniform. 

How do MPVs impact high-speed trading? 

A.3. MPVs impact all trading participants. MPVs set the minimum 

spread for quoting and trading of an instrument. Therefore, MPVs 

determine the price that all investors pay, both large and small, 

when entering or exiting the market. An MPV set too high will introduce substantial costs to investors. An MPV set too low can 

lower displayed liquidity and cause the appearance of increased 

price volatility. 

Q.4. What factors should be considered when determining the appropriate MPV? 

A.4. As I stated in my written testimony, our market is currently 

designed as a ‘‘one size fits all’’ market. More regulatory flexibility 

around MPV and other market structure features should be considered in order to accommodate the wide spectrum of publicly traded 

stocks in our market. 

Q.5. Should there be different MPV’s for stocks of varying price or 

trading volume? 

A.5. Yes. ‘‘One size fits all’’ market structures are not appropriate. 

Q.6. Several witnesses mentioned the proliferation of order types 

that are designed for high-speed traders. 

How do the order types available to trades in the United States 

compare to those available in markets abroad? 

A.6. U.S. markets are highly complex and fragmented as a result 

of regulatory changes. Market participants have requested a variety of order types to address their unique needs to deal with this 

highly complex and fragmented market. These order types are filed 

with the Securities and Exchange Commission and approved by the 

SEC. 

Q.7. How do exotic order types advantage or disadvantage retail investors, institutional investors, exchanges, and high-speed traders? 

A.7. A variety of order types have been designed and made available to investors, both retail, institutional, and professional. These 

order types, which range from simple to complex, have been designed, delivered, and accessible to meet the unique needs of these 

investors. 

Q.8. Please list those order types that you believe could be eliminated without doing harm to markets. 

A.8. Because many order types have been designed to meet the 

unique needs of investors both large and small, such an analysis 

would require the solicitation of views from a very broad audience 

to ensure that certain order types are not mistakenly eliminated. 

Q.9. The increased fragmentation of exchanges and dark pools complicates the task of developing a market wide approach to data aggregation and analysis by regulators. 

79 

What type of technology investments could advance the ability of 

the Securities Exchange Commission and the Commodity Futures 

Trading Commission to better monitor markets and develop a market wide approach to data? 

A.9. The two agencies seem to recognize that market structure and 

technology advancement issues present challenges to monitoring 

our modern markets. Consequently, the agencies have been openly 

discussing these market surveillance issues with interested parties 

including Virtu. We believe the design and implementation of a 

multimarket surveillance system is very achievable and will deliver 

the long term benefits needed to protect our markets. 

80 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

STATEMENT OF SENATOR CARL LEVIN 

I would like to thank Chairman Jack Reed, Ranking Member Crapo, and all my 

colleagues on the Securities, Insurance, and Investment Subcommittee for holding 

this hearing. 

Millions of American workers and their pension funds have long put their savings 

into the U.S. capital markets in hopes of a better retirement and better future. In 

recent years, though, a number of headline-grabbing events have raised serious 

questions about our markets in the minds of ordinary Americans, sophisticated investors, policy makers, and regulators. 

• Are our markets too fragile and vulnerable to collapse? 

• Are our markets fair for all investors? 

• And are investors, who we need to fund the growth and development of our 

companies and our economy, fearful about subjecting their savings to these 

markets? 

Nearly 2 years ago, some of you joined with members of the Permanent Subcommittee on Investigations, which I chair, in a joint hearing to examine the efficiency, stability, and integrity of the U.S. capital markets. At that hearing, held in 

the wake of the so-called Flash Crash, experts raised a number of important issues, 

and we highlighted a number of potential regulatory improvements. 

I am pleased that the SEC took some steps to limit dangerous holes in our market 

regulation, such as unlimited, unsupervised direct market access. And just recently, 

the SEC finally issued a rule that will someday create a consolidated audit trail. 

These and other recent steps are a good start, but they are little more than BandAids. As anyone who has watched or participated in the markets in recent years 

knows, more must be done. 

It is time for a broad reexamination of the actual workings of our markets. When 

the horse and buggy gave way to the automobile, our national infrastructure needed 

an upgrade. During these tumultuous times, while we as a country learned how to 

take advantage of this great new innovation, there were innumerable horrific accidents: cars running into older horse-drawn vehicles; cars running off the edges of 

unpaved roads; and cars simply crashing into one another. 

What our country learned is that everything needed an upgrade. The roads themselves needed upgrades. They needed to be wider and more stable to bear the heavier traffic. The cars themselves needed to be safer. And the drivers needed an upgrade. They needed to adopt and follow ‘‘rules of the road,’’ like when to make a 

left hand turn and what to do when an emergency vehicle drives by. These upgrades 

needed to be enforced. Roads need to be inspected, as did the cars driving on them. 

Drivers needed to be tested, and police officers needed to ensure that drivers followed the rules. 

As the cars got faster over the next several decades, the benefits and needs for 

upgrades grew as well. We needed seatbelts and airbags. Roads needed to be wider, 

straighter, and bridges sturdier. Drivers needed to be smarter too. Those driving 

unique vehicles, like tractor trailers and busses, needed further training. And enforcement also needed upgrades. Because police officers can’t be everywhere at once, 

speed cameras and red-light cameras have started to pop up. 

The goals of all of these innovations were simple: (1) minimize the number of 

crashes, and (2) make the crashes that do occur less harmful. 

In recent years, our capital markets have undergone a transformation that is no 

less stunning. The old New York Stock Exchange floor has been hollowed out. The 

screaming that once typified the floor is now replaced with the whir of computers. 

Traditional market makers have given way to computer trading firms with servers 

located right next to the computers of the trading venues. 

Computerized traders use automated trading systems to very quickly place and 

cancel orders—more than 90 percent are canceled—to make markets and arbitrage 

very small price differences between markets. In this very competitive industry, milliseconds can be the difference between millions in profits and significant losses. Because of that, computerized trading firms now pay thousands of dollars a year for 

the right to special proprietary data feeds from exchanges and other execution 

venues. Many rent space, for another hefty sum, to collocate their servers at execution venues. Doing this reduces the response time by a few milliseconds, which is 

worth millions of dollars to these firms. Orders to buy or sell stock are diced by computers into small bits, routed in milliseconds to any of several dozen venues, and 

executed in fractions of a second. All while other computerized trading programs are 

looking to sniff out those orders, and sneak in front of them for a profit. 

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Investors who hold onto stocks for weeks, months, and years comprise less of the 

market than ever, giving way to computer trading programs holding onto stocks for 

fractions of a second. 

It is not surprising that this rapid development has resulted in more than our 

share of crashes, the most notable of which was the Flash Crash. And there are 

plenty of lessons to be learned from just that event. 

But, since then, numerous other crashes and technological errors have roiled the 

markets. Many investors were shocked to see the failure of the IPO of BATS Global 

Markets. BATS is itself a major exchange on which investors trade more than 500 

million shares a day. Yet, due to a computer glitch on BATS’s own systems, its IPO 

went haywire and ultimately had to be shelved. 

Just a few months later, another high profile IPO faced a different set of technical 

glitches. This time, trading glitches at Nasdaq left investors who tried to buy shares 

of Facebook, one of the most well-known and valuable IPOs in recent memory, with 

no idea whether their trade had been completed for hours, and, reportedly in some 

cases, days. Now, Facebook stock is worth barely half of its initial value, and lawsuits continue to be filed as Nasdaq, the underwriters, and investors fight over the 

damage. 

Still another computerized trading error occurred last month. This time, Knight 

Capital, one of the largest market makers, nearly collapsed when a rogue trading 

program went unchecked for just about 40 minutes. Despite new rules intended to 

stop wild price swings, millions of unintended trades flung prices and volumes in 

about 150 stocks all out of whack. Ultimately, a seemingly small programming 

glitch cost Knight about $440 million and forced them to sell off a 73 percent stake 

in the company, nearly wiping out existing shareholders. 

These accidental trades were one of the first significant tests of the rules that the 

SEC put in place after the Flash Crash. Most of those protections weren’t triggered. 

While this is certainly a warning to other firms about the dangers of a single software error, it should also be a warning to regulators about the strength and security 

of our markets. 

And these incidents don’t include the dozens of ‘‘mini-crashes’’ that have occurred 

in single issuers. For a company and their employees, it must be more than a bit 

discomforting to watch your stock price spike and plummet over minutes, often for 

no discernible reason. It’s past time for some more upgrades. 

Regulators don’t yet have effective systems to stop catastrophic collapses, and 

they lack the ability to see all of the activity that’s occurring in all of the venues 

in a way that lets them understand what’s going on. The consolidated audit trail 

was proposed years ago. It doesn’t cover nearly enough activity, and is still years 

away from being a reality. 

Regulators don’t seem to know what the traders are really doing. While so-called 

‘‘naked access,’’ wherein traders are given unfettered access to the trading markets 

without real oversight, is banned, there are still no driving tests for these traders. 

There are still no licenses for these traders, unless they opt into them. 

System failures are not the only concerns with our markets. There are very real 

questions about whether our U.S. capital markets are fair. Since the joint PSI/Securities Subcommittee hearing in 2010, there have been a number of high-profile instances where some market participants have been given preferences over ordinary 

investors, and where our opaque market structure has allowed trading abuses that 

have victimized unwitting investors to go otherwise undetected. 

Recently, the Wall Street Journal reported how some exchanges have created special order types that allow sophisticated algorithmic traders to jump the line and 

take advantage of ordinary investors. In some cases, exchanges are creating order 

types for sophisticated traders to use that are designed not to trade. Some are hidden from few. These orders aren’t about maintaining fair and transparent markets. 

Just the opposite. 

Also recently, the NYSE settled charges by the SEC that it sent its data feeds 

to certain customers faster than the data it provided to other market participants. 

Collectively, these reports show that some traders seem to be given a leg up on the 

rest of us. They get information faster. They process it faster. And they are given 

tools to take advantage of that information to the detriment of the rest of the market. 

One of the more offensive examples of this type of favoritism is in so-called ‘‘flash 

orders,’’ where a venue ‘‘flashes’’ an order to a select group of favored customers before showing that order to the rest of its members. What’s to prevent one of those 

favored customers from taking advantage of that information to the detriment of the 

customer whose order was flashed? Not much. Senator Schumer and I, and others, 

have called for the banning of this practice. But, years later, that still hasn’t happened. 

82 

There are other fairness risks. Given the complexity of order routing, and the incentives of the current ‘‘maker/taker’’ model, brokers are often faced with a conflict 

of interest. They can send an order to a venue with the best price, or they can send 

it to the venue which gives them the most profit. If these decisions were made by 

humans, we could ask them why they make particular decisions. But they aren’t. 

These decisions are buried deep within the codes of smart order routers. Institutional traders and ordinary investors alike should wonder whether the smart order 

router is really working for them or their broker. To be sure, many brokers are fulfilling their duties to their customers and getting the best executions, but how is 

the customer to know? How is a regulator going to know? 

Another significant challenge is the lack of transparency in the off-exchange trading venues. In a case last year, the SEC fined Pipeline Trading Systems, a dark pool 

operator, for trading in front of customers, taking advantage of their role in the center of the marketplace. While Pipeline was supposed to be matching up buyers and 

sellers, it was secretly trading against its customers, often for a profit. Is this type 

of activity happening at other dark pools? Most of them disclose that the firm itself 

may take the other side of a trade. So should it be ok if the customer knows that 

he’s likely to be taken advantage of? What’s his alternative? Is it to post the order 

on the New York Stock Exchange and be taken advantage of there? 

I look forward to today’s hearing, and we should all look forward to pressing our 

regulators to address these questions. For more than a century, American markets 

have been the envy of investors across the world. We must continue to examine the 

regulations and structure that has been put in place to ensure that today’s equity 

market is fair for all and has the right protections in place to prevent technical 

glitches from causing a collapse. 

Once again, I wish to thank Chairman Reed and Ranking Member Crapo for holding this important hearing today. I hope this hearing will lead to a strengthening 

of our markets to ensure that they remain the best in the world in coming years. 

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STATEMENT OF MICAH HAUPTMAN, FINANCIAL CAMPAIGN 

COORDINATOR, PUBLIC CITIZEN’S CONGRESS WATCH DIVISION 

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STATEMENT OF CAMERON SMITH, PRESIDENT, QUANTLAB 

FINANCIAL, AND RICHARD GORELICK, CEO, RGM ADVISORS 

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SUMMARY AND EXCERPTS FROM ‘‘HIGH FREQUENCY TRADING AND 

PRICE DISCOVERY’’ BY TERRY HENDERSHOTT AND RYAN RIORDAN