UNITED STATES OF AMERICA

 COMMODITY FUTURES TRADING COMMISSION

 SECURITIES AND EXCHANGE COMMISSION

 FIFTH MEETING OF THE CFTC-SEC JOINT ADVISORY

 COMMITTEE ON EMERGING REGULATORY ISSUES

 Washington, D.C.

 Friday, February 18, 2011
 2

 1 PARTICIPANTS:

 2 CFTC Commission Members:

 3 GARY GENSLER, Chairman

 4 JILL SOMMERS, Commissioner

 5 MICHAEL V. DUNN, Commissioner

 6 SCOTT D. O'MALIA, Commissioner

 7 SEC Commission Members:

 8 MARY SCHAPIRO, Chairman

 9 ELISSE B. WALTER, Commissioner

 10 Presenters:

 11 RICK KETCHUM

 Financial Advisory Regulatory Authority

 12

 JACK BRENNAN

 13 The Vanguard Group Inc.

 14 Advisory Committee Members:

 15 BROOKSLEY BORN

 16 ROBERT COOK

 17 ROBERT ENGLE

 18 ANDREI KIRILENKO

 19 MAUREEN O'HARA

 20 SUSAN PHILLIPS

 21 DAVID RUDGER

 22 JOSEPH STIGLITZ
 3

 1 P R O C E E D I N G S

 2 (9:30 a.m.)

 3 CHAIRMAN GENSLER: Welcome. I'm going

 4 to see if we can call this meeting to order. I'm

 5 acting as Co-Chair here to call this Fifth Meeting

 6 of the Joint CFTC-SEC Advisory Committee on

 7 Emerging Regulatory Issues to order. The date is

 8 February 18, 2011, and this meeting is held in

 9 accordance with the Government's Sunshine Act. We

 10 are joined by distinguished members of the

 11 Advisory Committee, Brooksley Born, Susan

 12 Phillips, Rick Ketchum, Jack Brennan, Maureen

 13 O'Hara, David Rudger and Robert Engle and we thank

 14 you for your service.

 15 As we have done in prior meetings of

 16 this Committee, Co-Chair Schapiro and I will share

 17 the presiding officer duties. First I would like

 18 to offer Chairman Schapiro the opportunity to make

 19 some opening remarks. Chairman Schapiro?

 20 CHAIRMAN SCHAPIRO: Thank you very much,

 21 Gary. Good morning everyone. I'll be very brief.

 22 I want to remind everyone because we all are very
 4

 1 focused on what a vital role our markets play in

 2 capital formation and the lives of millions of

 3 Americas, for that reason at the SEC as you all

 4 know we began a comprehensive review of market

 5 structure in 2009 and of course that's also why

 6 both of our agencies have spent so much time

 7 considering the events of May 6, trying to

 8 analyze, understand and respond to them as

 9 effectively as we can. That was of course the day

 10 in which the markets temporarily though

 11 demonstrably failed to perform in the way which we

 12 reasonably expect them to. It's in that spirit

 13 that the members of the Advisory Committee were

 14 asked to provide us with their own perspectives on

 15 the events of that day. I'm especially interested

 16 in hearing their views on the effectiveness of the

 17 various measures we've put in place since May 6

 18 and on any additional targeted measures they

 19 believe we should explore further that could

 20 directly address the risk of reoccurrence. Their

 21 observations will doubtless provide us with

 22 important insights and ideas and I'm counting on
 5

 1 them to spur additional comment and analysis from

 2 investors and market participants, and I want to

 3 thank you all again for your efforts and I'll turn

 4 it back to Gary.

 5 CHAIRMAN GENSLER: Thank you so much.

 6 I'm pleased to be joined by Chairman Schapiro in

 7 welcoming you all here. This is the third time

 8 this week that Chairman Schapiro and I have had

 9 the ability to share a table. It was an honor to

 10 testify in front of Congress twice this week

 11 together, but we're also focused on strengthening

 12 our markets beyond what we're doing in the

 13 Dodd-Frank Act in that we're focused on the events

 14 of May 6 and strengthening our markets. I'd also

 15 like to thank Chairman Schapiro, her fellow

 16 Commissioners, the staff of the SEC and all that

 17 they have done not only on May 6 but the

 18 incredibly collaborative working relationship on

 19 the Dodd-Frank Act. And I'd like to thank the

 20 staff of the CFTC for all of their hard work

 21 planning this meeting and all of the follows-ups

 22 on May 6, and also thank my fellow Commissioners
 6

 1 and recognize Commissioners Mike Dunn, Jill

 2 Sommers and Scott O'Malia who are here, and I

 3 believe that Commissioner Chilton is tied in. Is

 4 that right?

 5 COMMISSIONER CHILTON: Yes, I'm here,

 6 Mister Chairman.

 7 CHAIRMAN GENSLER: Today's meeting is

 8 intended to give the Joint Advisory Committee an

 9 opportunity to share their recommendations with

 10 the CFTC and SEC and they have had several months

 11 to review and consider the staff reports and well

 12 as four open meetings and hearing from witness and

 13 they have met in subcommittees as well. The

 14 Committee is comprised of extremely experienced

 15 experts who have been introduced and I look

 16 forward to hearing their recommendations.

 17 At both the CFTC and SEC, one thing that

 18 we are quite sure of is that the means of

 19 communication and technology will continue to

 20 advance and affect our markets. This was true in

 21 the 19th century when telegraph led to the

 22 introduction of the tickertape. It was also true
 7

 1 in the early 20th century when telephones were

 2 first used to have a central quote system where

 3 market participants actually got an instantaneous

 4 bid offer spread over the telephone. The year was

 5 1929 I'm told. It was further true during the

 6 last decade when markets that we oversee here at

 7 the CFTC went from open outcry to now

 8 approximately 90 percent electronically traded.

 9 So where market makers used to be on the floor of

 10 the exchanges, they now often sit at computer

 11 miles away or even on another continent. And

 12 while market participants used to be involved in

 13 each of their trades, they now often rely on

 14 algorithms to execute those very trades. Humans

 15 are much frequently relying on the judgment that

 16 they've programmed into a computer to execute

 17 their trading strategies and the markets have

 18 evolved to where we increasingly find more Watsons

 19 competing with the Ken Jennings and Brad Rutters.

 20 Regulators cannot assume however that algorithms

 21 in the markets are going to be as well tested or

 22 well supervised as we think and see where Watson
 8

 1 apparently was in winning Jeopardy! Our

 2 regulations have to adapt to the markets

 3 increasingly as we move from man to machine.

 4 The events of May 6 were start reminders

 5 of the need for regulators to evolve as rapidly as

 6 the markets and only through adaptive regulation

 7 can hedgers and investors have confidence in the

 8 markets and can there be market integrity. We

 9 must be sure that we as an agency make the

 10 necessary investments in technology as it

 11 continues to advance. We too as an agency can't

 12 just rely on men and women, we have to rely on

 13 machines. We must ensure that our regulations

 14 advance as well.

 15 The CFTC will consider the Joint

 16 Advisory Committee's recommendations as we look

 17 for ways to strengthen the derivatives markets and

 18 I thank them for their thoughtful advice. It

 19 comes also at a particularly important time as we

 20 look at Dodd-Frank rule-writing and the swaps

 21 marketplace. So we're going to share your

 22 recommendations with our 31 teams and we'll post
 9

 1 them on our comment files and on our public

 2 website and hear from the public hopefully as well

 3 on this. I am particularly interested in a number

 4 of topic areas that I know you are going to

 5 discuss today about cross-market circuit breakers,

 6 pretrade risk safeguards, effective testing of

 7 risk- management controls and supervisory

 8 requirements regarding these algorithmic trading

 9 systems.

 10 Again I want to thank Chairman Schapiro,

 11 the SEC and my fellow Commissioners. I think

 12 we're going to be recognizing fellow Commissioners

 13 for any thoughts or opening statements.

 14 Commissioner Dunn?

 15 COMMISSIONER DUNN: Thank you, Mister

 16 Chairman. I just want to thank the distinguished

 17 Advisory Group for their diligent work on this and

 18 it was a little awkward dividing them up into two

 19 different groups and they had to work through an

 20 intermediary to talk to each other to get around

 21 the Open Meeting Rule, but they did an excellent

 22 job. This report is extremely timely for us as we
 10

 1 go about the implementation of Dodd-Frank, but

 2 also as we look at the mergers that are taking

 3 place in this industry. So let me echo my thanks

 4 to all of you and let me get on the theme that the

 5 Chairman started with Jeopardy! for all of us

 6 Jeopardy! junkies. When Watson missed something,

 7 Watson really missed it and I'm reminded of when

 8 he thought Toronto was a U.S. city and that tells

 9 us how far skewed that computers cam be. Again I

 10 thank you very much for these recommendations.

 11 COMMISSIONER SOMMERS: Good morning. I

 12 don't have an opening statement but want to also

 13 echo my thanks to all of you for your dedication

 14 and the time that you have spent on these very

 15 difficult issues and really appreciate the report

 16 that you've provided us with. Thank you.

 17 COMMISSIONER O'MALIA: I'd like to also

 18 extend my thanks very much for the hard work

 19 you've put into this report. This morning I

 20 forwarded the report on to our Technology Advisory

 21 Committee Subcommittee on Pretrade Risk

 22 Functionality so they could review it and that
 11

 1 would be contributing to our efforts on that

 2 subcommittee and the Technology Advisory

 3 Committee. We have a meeting on March 1 and this

 4 will contribute to that discussion, so I greatly

 5 appreciate your efforts in that.

 6 CHAIRMAN SCHAPIRO: Thank you. I think

 7 we may also be joined on the phone by SEC

 8 Commissioner Elisse Walter. Today the Joint

 9 Advisory Committee is delivering a summary of

 10 recommendations concerning the market events of

 11 May 6. This is the product of considerable

 12 thought and effect by the committee and we are

 13 genuinely grateful for your efforts. But in

 14 particular I want to acknowledge and thank Jack

 15 Brennan and Rick Ketchum who have chaired the

 16 subcommittees, taken on a great deal of the

 17 organizational responsibilities that were needed

 18 to produce the report and we are enormously

 19 indebted to you for all your efforts. And for

 20 those of you who are watching webcast, the report

 21 itself can be downloaded from either the SEC or

 22 the CFTC's website.
 12

 1 CHAIRMAN GENSLER: I will now turn the

 2 floor over to Jack and Rick and the entire

 3 committee who will present the report and

 4 recommendations. Following that, the

 5 Commissioners and staff of the CFTC and SEC will

 6 have an opportunity to ask questions. I'd like to

 7 turn over the floor to Jack Brennan and Rick

 8 Ketchum.

 9 MR. KETCHUM: Thank you, Chairman

 10 Gensler, Chairman Schapiro and Commissioners.

 11 First, I think I speak for the entire Commission

 12 for again thanking you for the honor and trust

 13 including us in its Advisory Committee and the

 14 strong efforts of your staff to provide us

 15 support. It has been I think a good start and

 16 work that the committee has taken very seriously,

 17 but it fundamentally begins with the commitment

 18 and the quality of the two agencies and we are

 19 very honored to be able to provide you and support

 20 that we can.

 21 I will speak very briefly in an overview

 22 and then Jack I think will work through the
 13

 1 recommendations with the insight of each of the

 2 Commissioners. Again, one last thank you. I want

 3 to emphasize that I've been on many committees

 4 over the years. This one has been within the

 5 restrictions of FACA remarkably collegial. It has

 6 been awkward to have two subcommittees but we're

 7 so close at this point we're talking about

 8 reunions. It's been a good thing. I do say that

 9 it has been remarkable the commitment and

 10 contribution of each committee member. So I do

 11 believe you can view this as truly a collegial

 12 product.

 13 From an overview standpoint I would note

 14 that certainly speak for my committee that our

 15 thinking and approach began from three basic

 16 precepts. The first of those precepts was

 17 recognizing the conscious effort of both agencies

 18 to encourage competition and ensure low barriers

 19 to access to entry and with that to provide a

 20 competitive and efficient marketplace for the

 21 benefit of investors. Those conscious efforts of

 22 the two agencies has led to a market environment
 14

 1 that is quite vibrant, that is extremely liquid

 2 and that provides low cost relatively speaking for

 3 investors, all-important attributes. It does

 4 however with respect to the first of our three

 5 tenets result when combined with the dramatic

 6 changes in technology and electronic trading in a

 7 marketplace that under pressure and in times where

 8 there is the potential for extreme volatility

 9 exhibits some level of fragility. We think that

 10 expresses to some degree simply the reality of a

 11 highly electronic, low barrier to entry, somewhat

 12 highly fragmented marketplace and that with that,

 13 that simply cannot be ignored and needs to be

 14 addressed just as we note specifically in the

 15 recommendations how pleased we are of the steps

 16 that the Commissions have already taken in

 17 recognizing that reality.

 18 The second precept is that from early on

 19 in my government career after the crash of 1986,

 20 there was a recognition of the importance of

 21 coordination across the derivative and equity

 22 markets given both the importance of those markets
 15

 1 and the fundamental interlinked nature of them.

 2 From our committee's perspective, that has been if

 3 anything given the nature of electronic trading

 4 become more critical and we speak to that in the

 5 report and think again that the demonstrably

 6 closer coordination that I can recall in my 30

 7 years of interacting with the two agencies is

 8 remarkable credit to both agencies, to both

 9 Chairmen and extremely important to really push

 10 further.

 11 The third precept is that in a world

 12 that has by nature some level of fragility and in

 13 a world that is extraordinarily fast, we believe

 14 the third piece is to look very closely at

 15 questions of how to ensure levels of price and

 16 transparent liquidity that is at least able to

 17 interact in times of pressure and at times of

 18 stress with efforts to try to avoid disincentives

 19 from the standpoint of transparent liquidity and

 20 where possible the ability to provide incentives

 21 for it.

 22 That leads to breaking with the report
 16

 1 in essentially four related portions of

 2 recommendations, the focusing on direct measures

 3 to respond and address to the existing environment

 4 in high-volatile times that result in

 5 recommendations that involve a carrying on of

 6 efforts that the Commissions have put in place

 7 already. The second area looks to efforts from an

 8 oversight and supervision standpoint to address

 9 very clearly the questions of access and direct

 10 access into the market by a wide range of

 11 participants and the manner in which those

 12 participants in an electronic environment should

 13 be provided that access and the accountability and

 14 responsibility of both of those participants and

 15 those who are active sponsors of their orders must

 16 have.

 17 The third piece to repeat what I said

 18 focuses again on efforts and possible areas for

 19 the Commission to focus on to encourage and to

 20 remove and disincentives to transparent liquidity.

 21 The fourth area focuses on information provisions,

 22 recognizing the crucial importance both from a
 17

 1 supervision standpoint and from the standpoint to

 2 avoid unnecessary uncertainty in providing rich

 3 information on a timely basis both to the

 4 marketplace as a whole and investors who operate

 5 in that marketplace and to the Commissions

 6 themselves from the standpoint of their oversight

 7 responsibilities and those other entities from an

 8 independent regulation standpoint that will also

 9 stand with responsibility for regulatory

 10 oversight.

 11 That in essence is where our report

 12 focuses. I would like to end with just one

 13 important note and I'll speak personally for

 14 myself but I believe is shared by all the

 15 committee members. We are honored to be a member

 16 of this Advisory Committee. We feel quite

 17 strongly with respect to the importance of the

 18 areas identified and feel that the recommendations

 19 that we have made are important and deserve

 20 serious consideration. But we also recognize very

 21 much the professionalism and perspective of the

 22 agencies themselves. We view ourselves precisely
 18

 1 as what our name is. We have provided you our

 2 best efforts in advice. We have great confidence

 3 in the capability of the Commissions to take this

 4 input along with the other many inputs you receive

 5 as well as your own professionalism in making

 6 sound decisions in these areas. Thank you.

 7 MR. BRENNAN: Thank you, Rick. That

 8 introduction sets up the way we would like to

 9 proceed this morning. What we would like to do is

 10 present those four subcomponents to our report in

 11 sequential order, have a conversation among

 12 ourselves and with the Commissions if this is all

 13 right with you Chairman Gensler and Chairman

 14 Schapiro because they are very much interrelated.

 15 None of the recommendations stands on its own with

 16 respect to volatility or with respect to liquidity

 17 and so on. So I will share with you the

 18 recommendations so that you hear them. I will not

 19 read you the whole report I know much as Mary

 20 would like that, but that will have to wait for

 21 another day. And then we will deepen the

 22 information about those recommendations through
 19

 1 conversation. Each of the Joint Advisory

 2 Committee members has opinions. There are things

 3 in these topics that didn't make the report as

 4 well because we tried to focus our attention where

 5 we had a consensus so our colleagues will feel

 6 free to offer other thoughts that might be there

 7 for additional investigation by the Commissions

 8 and our hope is to make this a fulsome

 9 conversation about each topic.

 10 With that background, let me start out

 11 with the broad subject of fragility and

 12 volatility. Chairman Schapiro, in response to

 13 your questions, we have one comment/commendation

 14 and then we have four recommendations. The

 15 comment/commendation really is the strong

 16 concurrence of the committee with respect of the

 17 SEC working with the exchanges and FINRA have

 18 already taken to first create single-stop pauses

 19 and circuit breakers for Russell 1000 stocks and

 20 actively traded EFTs, to enact rules that provide

 21 greater certainty as to where and when trades will

 22 be broken when there are aberrant events in the
 20

 1 markets, and then the third step is to implement

 2 minimum quoting requirements to eliminate stub

 3 quotes. We believe as a group that those are

 4 vitally important to the restoration of confidence

 5 in the markets and we offer our strong

 6 concurrence. As I said, my editorial would be

 7 commendation for the quick action in the way those

 8 have served the markets and investors very, very

 9 well.

 10 With respect to other recommendations in

 11 the broad category of market fragility and

 12 volatility we have four. The first is that we

 13 recommend that the Commissions require that the

 14 exchanges and FINRA pause rules should be expanded

 15 to all but the most inactively traded equities,

 16 EFTs, options and single-stock futures. That

 17 probably won't surprise you given our belief that

 18 they are a very positive force in the market

 19 today. The second recommendation in this category

 20 we have is that we recommend that the SEC work

 21 with the exchanges and FINRA to implement a

 22 limit-up/limit-down process to supplement the
 21

 1 existing pause procedures and that Commissions

 2 clarify whether Securities Option Exchanges and

 3 Single Stock Futures Exchanges should continue to

 4 trade during those limit-up/limit-down periods. I

 5 think I can speak for most of us that the early-on

 6 discussions about what happens in the futures

 7 market vis-à-vis what happens in the stock market

 8 that it was quite important to us to get a sense

 9 that if we can do this, this can help very much

 10 with volatility and the confidence in the markets.

 11 Chairman Gensler?

 12 CHAIRMAN GENSLER: Maybe I'll hold my

 13 question.

 14 MR. BRENNAN: I'm going to do four. So

 15 that's the second. The third is we recommend that

 16 the CFTC and the relevant futures exchanges

 17 evaluate whether a second tier of futures limits

 18 with longer timeframes should be instituted when

 19 the 5-second limit does not attract contra- side

 20 liquidity. Again some lessons of May 6. Finally,

 21 with regard to the broad market circuit breakers,

 22 we recommend that the Commissions evaluate that
 22

 1 system of system-wide circuit breakers and

 2 consider three things. First, reducing at least

 3 the initial trading halt to a period of time that

 4 is as short as 10 minutes from the existing rules

 5 today; allowing the halt to be triggered as late

 6 as 3:30; and finally, we recommend looking

 7 importantly at a more representative index, that

 8 being as the S&P 500 as the triggering mechanism

 9 which has relevance both on the stock and the in

 10 the futures markets.

 11 Those four recommendations we believe

 12 will help address the issues of market fragility

 13 and volatility, and as I said, importantly we

 14 believe the quick steps taken after May 6 were

 15 very effective and those would be complementary

 16 and additive to those steps that were taken. We

 17 would stop there and I would ask the committee

 18 members, or Chairman Gensler we'll let you in

 19 right now.

 20 CHAIRMAN GENSLER: I'll wait my turn.

 21 MR. BRENNAN: Additional commentary,

 22 Maureen?
 23

 1 MS. O'HARA: I think one of the things

 2 that underlies a lot of our thinking in this area

 3 has to do with the role of uncertainty in

 4 high-speed markets. A typical approach to think

 5 about is risk and return in markets, but when

 6 markets as quickly as they do not, you also have

 7 to explicitly recognize the role that uncertainty

 8 plays as distinct from risk. I think one of the

 9 things that underscored the behavior of the

 10 markets on May 6 was uncertainty, uncertainty from

 11 market makers about where the market was going,

 12 uncertainty about limit order traders about

 13 whether or not the books were empty or not empty

 14 and uncertainty about whether orders were going to

 15 broken or not and cancelled. So a lot of what I

 16 think motivated a lot of our discussion in our

 17 committee was the notion that in a high-frequency

 18 world, uncertainty plays a role and the challenge

 19 of uncertainty is that when people become

 20 uncertain the solution to uncertainty is

 21 nonparticipation and nonparticipation in turn

 22 leads to the challenges that we saw on May 6.
 24

 1 So I think underlying a lot of what we

 2 have here is an explicit recognition that part of

 3 what market regulation now has to do is limit

 4 uncertainty. How do you do that? You limit

 5 uncertainty by limiting the amount of movement

 6 that a price can have before it can fall off the

 7 map like it did on May 6. You limit uncertainty

 8 by reassuring investors that trading will be

 9 halted before things can really get out of

 10 control. And you limit uncertainty through some

 11 of the actions that you took in really defining

 12 when orders will be broken and when things go

 13 forward. So I just want to throw out that as an

 14 important aspect and an important perspective to

 15 think about what led to a number of these

 16 suggestions.

 17 MR. BRENNAN: That is actually a great

 18 theme, Maureen, just as an editorial comment.

 19 It's a terrific theme.

 20 MS. O'HARA: Thank you, Jack.

 21 MR. RUDGER: I have had some particular

 22 interest in the market-wide circuit breaker since
 25

 1 in 1987 when I was chairman of the SEC we

 2 introduced those circuit breakers and my

 3 observation is that things have changed

 4 dramatically and I urge that the Commissions not

 5 only look at the three recommendations we've made

 6 but look at the entire area in great detail to ask

 7 what the purpose of these circuit breakers is and

 8 how the circuit breakers should be changed in

 9 order to recognize the new high-frequency trading

 10 environment. It is a different world and there

 11 are many suggestions as to what should be done, so

 12 I urge a very detailed look at that area.

 13 MR. BRENNAN: Brooksley?

 14 MS. BORN: When I was chair of the CFTC

 15 we worked on and amended the s circuit breaker so

 16 I'm particularly interested in their need for

 17 further work today. I feel that in the

 18 Commissions' work on these issues it's extremely

 19 important, and we believed this in the late 1990s

 20 as well, to ensure careful coordination across

 21 securities and derivatives markets to the extent

 22 feasible both as to market-wide circuit breakers
 26

 1 and other actions and single- stock actions as

 2 well. This should include pauses, circuit

 3 breakers, periods of limit-up/limit-down.

 4 MR. BRENNAN: Susan?

 5 MS. PHILLIPS: As we were discussing in

 6 coming to these various recommendations, it became

 7 obviously very clear that there are a lot of

 8 different participants coming to these markets

 9 that are used to very different regulatory

 10 environments. It's not CFTC-SEC registrants

 11 participating in these markets, but you've got

 12 bankers coming to the table now and they're used

 13 to a very different kind of environment.

 14 Consequently I think some of Maureen's comments

 15 about uncertainty get exacerbated when people

 16 don't know what is going on. They're used to

 17 their own environments and so they pull back and

 18 you get this gridlock that happens. I think one

 19 of the amazing things of May 6 is that the

 20 recovery did occur as quickly as it did to the

 21 integration of the markets is becoming more and

 22 more complete, but we've got these clashing
 27

 1 regulatory regimes coming together. We tried to

 2 think about what worked in some markets and could

 3 it be moved to other markets. The

 4 limit-up/limit-down recommendation obviously has

 5 been a large part of futures markets for many

 6 years but has not been a part of securities

 7 trading. Quite frankly it works well in a

 8 pit-style trading environment or where you have it

 9 all going on on one market where you can get the

 10 information out fairly quickly about

 11 limit-up/limit- down. It's harder to know how

 12 it's going to work in fragmented securities

 13 markets so that when we say that we want you to

 14 take this in the spirit of an advisory capacity,

 15 all of these things have to be carefully looked

 16 at. I think we believe that limit-up/limit-down

 17 would add demonstrably to the certainty and

 18 understanding of how far things can move before

 19 they get halted and that that will be helpful to

 20 the markets but a lot of work is going to have to

 21 be done in figuring out how to make it work in a

 22 different market environment. There are plenty of
 28

 1 questions still left to be answered but in trying

 2 to bring these questions together, we're looking

 3 to try to find ways to help reduce this

 4 uncertainty and to make market participants feel

 5 confident that they can continue to trade even if

 6 you see a fair amount of volatility.

 7 MR. BRENNAN: Rob?

 8 MR. ENGLE: One of the things we discuss

 9 is extending the pauses to a bigger universe and I

 10 think a challenge that is implicit in that is how

 11 big a universe should it really be? What are the

 12 issues when you start talking about putting pauses

 13 on infrequently traded stocks? If they don't

 14 trade very often, then the primary time when

 15 prices move is when there is new information and

 16 it's new information that you want to allow the

 17 markets to respond to rather than stop them from

 18 responding to that. I think one of the issues in

 19 implementing or thinking about how to implement

 20 this sort of recommendation would be to what

 21 extent should these pauses have a different

 22 structure or perhaps not be applied all the way to
 29

 1 the most infrequently traded stocks or most

 2 illiquid traded stocks and derivatives? We don't

 3 have a particular suggestion as to how to do that,

 4 but I think that's an issue that we're very

 5 cognizant of.

 6 MR. BRENNAN: David?

 7 MR. RUDGER: I want to add one

 8 observation that's come to me as I've studied this

 9 and that is that although there is wide agreement

 10 that price discovery takes place in the futures

 11 markets, electronic trading has expanded the

 12 opportunity for price discovery to other venues.

 13 We have the ETFs which are providing an

 14 opportunity for price discovery, we have the

 15 options market which I think has really not been

 16 examined very carefully in terms of this analysis

 17 and we have the stock markets themselves with

 18 high-frequency trading allowing market price

 19 changes in milliseconds. So I think when we look

 20 at this whole environment, when you look at this

 21 whole environment, it's important for you to look

 22 broadly across all these markets and at least it's
 30

 1 my impression that some of the computerized

 2 traders are active in all the markets and they

 3 have preprogrammed their computers to take into

 4 account information in all four areas that I've

 5 talked about so that you really need to get your

 6 heads around the question of how is this computer

 7 trading going on? What are the areas that they

 8 are looking at when they are creating the

 9 algorithms and then ask what kind of stocks would

 10 you put in.

 11 MR. BRENNAN: Are there other comments

 12 from the committee? Let's turn it, Chairman, to

 13 Commissioners for questions for us, please.

 14 CHAIRMAN SCHAPIRO: I'd be happy to go

 15 first. Thank you. First of all, this is

 16 fascinating. I do love the theme of uncertainty

 17 and how much it's driven and while we put in place

 18 these different mechanisms, I don't think we were

 19 necessarily except maybe with respect to erroneous

 20 trades thinking about really tackling uncertainty

 21 head on so that I appreciate that theme tying

 22 things together.
 31

 1 I have a specific question. You talk

 2 about and you recommend that we evaluate the

 3 existing market-wide circuit breakers that apply

 4 as David just said across securities, equity

 5 options and futures markets and that we reevaluate

 6 the percentage price declines that would trigger

 7 the circuit breakers. You don't recommend a

 8 specific level and I couldn't tell whether you

 9 thought 10, 20 and 30 were too high or too low.

 10 What I'm most interested is any thoughts about how

 11 we get the balance right because if the view was

 12 that we should lower the thresholds, that's

 13 obviously going to cause the circuit breaker to be

 14 triggered more often and at the same time, we

 15 don't want to really disrupt continuous trading

 16 more than necessary. So if you have thoughts,

 17 Rick, already volunteering about how to think

 18 about that and how we get that balance right and

 19 what kind of data would be useful for us to

 20 collect as we go forward in that area.

 21 MR. KETCHUM: You correctly and

 22 perceptively noted that the committee did not
 32

 1 reach a conclusion on that issue and thought it

 2 would be really good for you to reach it. I think

 3 to me and just speaking for myself there are a

 4 couple of things to consider from the standpoint

 5 that relate in part to the other recommendations

 6 that are here. We are in a new world in which

 7 there are single-stock circuit breakers on the

 8 equity side that are roughly acknowledged and

 9 dealt with with respect to the single- stock

 10 options and single-stock futures markets. An

 11 important learning to be focused on is to how that

 12 addresses some of the fragility concerns that

 13 relate to system-wide circuit breakers which

 14 should be really about an extraordinary day in

 15 which there is no an easy ability to have

 16 instantaneous return of liquidity simply by

 17 adjusting price would be how I briefly summarize

 18 the difference, so I think part of this is

 19 learning and the Commissions learning from the

 20 standpoint of how single- stock circuit breakers

 21 work in evaluating that.

 22 The second piece is we make a
 33

 1 recommendation on the futures side which is based

 2 on the recognition of the thoughtful and

 3 well-designed approach from the futures markets of

 4 stop logic but raise concerns that though it works

 5 in most situations, that there is a cascading

 6 limit risk to the extent that liquidity doesn't

 7 electronically reappear and the question is at

 8 what timeframe you need and from our experience

 9 with people withdrawing, you need humans to make

 10 the decision to return to a market either to buy

 11 or sell and provide contra-side liquidity.

 12 One could design in a variety of ways.

 13 One could create some more coordination between

 14 limits at multiple levels that would make it

 15 perfectly sensible to leave the circuit breakers

 16 where they are or perhaps even drop them down more

 17 although personally I think they're probably about

 18 right where they are. If you didn't want to do

 19 that on an individual contract basis then there

 20 might be some arguments now that we think we're in

 21 a position particularly on the equity market to be

 22 able to reset more quickly and still effectively
 34

 1 whether the system-wide circuit breaker could be

 2 reduced. I at least view it as really an

 3 integrated set of questions as to how the

 4 Commissions work through both the single-stick,

 5 single- product circuit breakers and system-wide

 6 when there is a serious problem.

 7 CHAIRMAN GENSLER: If it's all right to

 8 ask, I take it that the committee's advice is on

 9 cross-market circuit breakers to shorten the

 10 timeframe to 10 minutes in essence. I'm seeing a

 11 lot of shaking heads. That's uniform.

 12 MR. KETCHUM: Right.

 13 CHAIRMAN GENSLER: And that it's silent

 14 in the report or there are differences is whether

 15 10-percent was right or whether there was any

 16 movement and thus you've sort of been silent and

 17 left that ball in the professional camp of the SEC

 18 and CFTC.

 19 MR. KETCHUM: I think that the key word

 20 is deference and not differences among the

 21 committee. This was something we really felt

 22 deserved the overview of the Commissions and also
 35

 1 the additional steps the Commissions might take.

 2 MR. BRENNAN: But no particular sense I

 3 think that we wanted to see the possibility of

 4 them triggered more often. I think that's safe to

 5 say and hope that some of these other mechanisms

 6 would make them trigger less often even though

 7 they haven't been triggered very often so that the

 8 market disruptions, and I'll tell you from my

 9 professional experience, and halts are something

 10 that we'd like to avoid at all costs and if you

 11 can get at it in a different way and have the same

 12 volatility minimization because certainly to

 13 retail investors a closed market can perpetuate

 14 problems that feed on themselves. Maureen?

 15 MS. O'HARA: I was going to add that I

 16 think part of what we spent a lot of time thinking

 17 about is the fact that the speed that allows

 18 markets now to do things that scare us also allow

 19 markets to do things that heal quickly and as we

 20 think about these sorts of circuit breakers and

 21 pauses we have to recognize that just as liquidity

 22 can depart very, very quickly now, it can come
 36

 1 back just as fast and markets opening and

 2 operating are always better. So in our view or at

 3 least in my view, what we want to do is not impede

 4 information which when there is bad information

 5 prices are going to fall or go up, but that

 6 information process will continue after the pause

 7 if that's really what's driving it. What we're

 8 trying to do is focus on these episodic periods

 9 where price changes are due to illiquidity issues

 10 that can be solved hopefully by the mechanisms

 11 that have led to them, the speed with which

 12 high-speed traders can come back in and replenish

 13 liquidity and that's a lot faster now than it used

 14 to be so that the need for very long pauses I

 15 think is really not compelling anymore.

 16 MS. PHILLIPS: As the Commissions look

 17 at this and you're used to doing pilot programs

 18 and trying things out, but bearing in mind that as

 19 you do that the rest of the market is getting used

 20 to things and the more confident that they become

 21 that the pauses are going to be lifted as quickly

 22 as possible, it may actually be a slightly moving
 37

 1 target as everybody becomes more educated so that

 2 it's not easy to just to pin a particular number

 3 at a point in time.

 4 CHAIRMAN GENSLER: I think that with

 5 cross- market circuit breaker as Maureen is

 6 saying, markets can adjust more quickly so shorten

 7 it to the 10 minutes, but you're not saying having

 8 them happen more often. You also have in that

 9 area to move to the S&P 500 as contrasted and I

 10 was curious if you wanted to say more on that.

 11 MR. BRENNAN: Knowing something about

 12 the S&P 500 I suppose with having built a business

 13 around it, it's a far more representative index

 14 and you could consider even broader if you wanted

 15 to, but if you think about the contracts that

 16 trade on the S&P as opposed to the Dow in terms of

 17 volume or anything else and the capitalization

 18 weighting as opposed to price weighting and so on

 19 on the broad representation of the S&P, it seemed

 20 to us to be a better representation of the markets

 21 if you will and not coincidentally have some

 22 cross-market characteristics that seem to us to
 38

 1 make it a better benchmark, Gary.

 2 CHAIRMAN GENSLER: I had one on your

 3 recommendation four and Rick was complimentary on

 4 something in the futures market, this stop-loss

 5 functionality, these 5-second pauses in the

 6 futures market. I want to make sure I understand

 7 the actual words here. You're saying that if

 8 liquidity doesn't come back on the contra-side,

 9 maybe it should be longer than 5 seconds. Does

 10 that mean if the market is going down and there is

 11 not liquidity on the upside?

 12 MR. KETCHUM: Yes. If there is not buy

 13 liquidity to respond and to stabilize. As you

 14 say, the first thing we want to emphasize is we

 15 think the stop logic design is extremely thought

 16 out and obviously worked here and is very

 17 effective. In fact, it's thought out to even deal

 18 with situations in which liquidity does not

 19 immediately reappear by effectively respreading

 20 out the available possible prices in which

 21 liquidity is allowed to come back in and though

 22 reoptioned but at least providing another period
 39

 1 of time for electronic response. Our concern was

 2 not that that it wasn't designed and that it would

 3 not be extremely effective in most circumstances.

 4 It was that in situations as we discovered from

 5 both the Commissions' studies and the testimony

 6 and our own observations, in which for a variety

 7 of reasons electronic traders withdraw because of

 8 uncertainty, that the timeframe involved and the

 9 reset at steadily lower prices could create the

 10 risk of a cascading limit environment in which

 11 there would be a dramatic reduction in price in

 12 the futures with obviously all the implications to

 13 the equity market that occurred without a period

 14 of time for some level of reflection that's beyond

 15 5 seconds or 10 seconds. The suggestion that we

 16 know the right way to design that was to look at

 17 whether at a point of an exceptional day in which

 18 that buy-side liquidity doesn't electronically

 19 return, how to encourage an opportunity for that

 20 buy-side liquidity to occur before the price moves

 21 too far so that there is some more effective

 22 option if the first one doesn't work. That's the
 40

 1 thinking. It is with the emphasis that it is up

 2 to the markets and the Commissions to work through

 3 what makes sense from a detailed standpoint, but

 4 that's the thinking.

 5 CHAIRMAN GENSLER: I think I got it.

 6 It's to ensure against cascading, and back to

 7 Maureen's concept, there might be such uncertainty

 8 that 5 seconds doesn't solve that uncertainty.

 9 MR. KETCHUM: Correct.

 10 CHAIRMAN GENSLER: I'm turning it back

 11 to other people on this section whether there are

 12 any questions. Mike?

 13 COMMISSIONER DUNN: Thank you, Mister

 14 Chairman. Let me ask you a question first. You

 15 said in your opening statement that this report is

 16 going to be incorporated into the 31 areas that

 17 we're working with. Will that give folks an

 18 opportunity to comment not only on this report but

 19 also on how it affects a particular rule that we

 20 may be looking at?

 21 CHAIRMAN GENSLER: I would hope so.

 22 This report is in our comment file and to the
 41

 1 extent that people wish to comment on this report

 2 or comment on this report's reflection on

 3 particular rules, that the public would find their

 4 way to our website and make comments both on this

 5 report and how it might reflect on any other

 6 related matters.

 7 COMMISSIONER DUNN: Mary, is the SEC

 8 going to do something similar to that?

 9 CHAIRMAN SCHAPIRO: Absolutely. We'll

 10 put it up on the website, we'll seek public

 11 comment on the report itself and then it obviously

 12 is directly related to a number of market

 13 structure initiatives we have underway. I don't

 14 know that we'll duplicate input into every single

 15 comment file, but we'll certainly cross-reference

 16 it and we would hope people would look at this in

 17 the context of commenting on other market

 18 structure rulemakings.

 19 COMMISSIONER DUNN: I asked that

 20 question of the Chairs because I wrote down some

 21 key words that I heard from the panel as they were

 22 making recommendations and it was uncertainty,
 42

 1 change, coordination, new people coming to the

 2 table, extending to a bigger universe, and it

 3 dawns on me that I think David what you said

 4 really came home to me because when I came on as a

 5 Commission at the CFTC in 2004, it was open

 6 outcry, electronic trading was just starting,

 7 globalization was there but it was a very small

 8 piece and high-frequency trading and collocation

 9 types of things weren't even thought of and we've

 10 seen in a very short time all of this happening

 11 which leads to this fragmentation that you've

 12 outlined here. But it appears to me for us that

 13 there is a lot of distrust of the other folks

 14 involved. Are other regulators going to be doing

 15 something similar to what we may be doing because

 16 this isn't just a problem in the United States,

 17 this is a global problem? There is distrust and

 18 are they going to do one thing at the SEC and

 19 another thing at the CFTC? Everybody I think

 20 agrees that we've got to address this problem but

 21 they all want to do it the way they're familiar

 22 with and not the way somebody else is familiar
 43

 1 with. How do we get to that common denominator of

 2 coming up with addressing this across the board

 3 for everyone? Scott, I think you're probably

 4 going to get the first challenge on this at your

 5 TAC meeting. But I would be interested in the

 6 panel's comments as to how do we sell this to

 7 everyone?

 8 MR. KETCHUM: It's a very thoughtful

 9 question which I don't think permits a simple

 10 answer, but I would note just a couple of things.

 11 One, it is clear that the two agencies are working

 12 more effectively than they have ever before. We

 13 recognize in the Dodd-Frank world that you have

 14 even greater responsibilities than the over-the-

 15 counter derivative side and the rest that will

 16 have to be thought through so I think the

 17 cooperative relationship that exists today across

 18 these agencies gives me great confidence that in

 19 the United States the approach will be thoughtful

 20 and coordinated.

 21 We have been cognizant and aware though

 22 not driven by similar efforts and analysis
 44

 1 occurring both in Europe through the E.U. and

 2 Canada with regard to questions of electronic

 3 trading and questions with respect to addressing

 4 volatility. I think you will see that some of our

 5 recommendations in latter parts that Jack will

 6 cover that are certainly not the same as things

 7 that have been raised in this countries but

 8 respond to similar concerns and with not

 9 dramatically different responses.

 10 For better or worse, while the markets

 11 are remarkably global from participants'

 12 standpoint, the marketplace outside of

 13 over-the-counter derivatives still seems to be

 14 fairly country focused so there will remains some

 15 ability to address this even with some

 16 difficulties. But Commissioner, I think you're

 17 absolutely right that the challenge for the United

 18 States and the CFTC and the SEC will be to work

 19 very closely with regulators across the globe and

 20 certainly those in North America and Europe where

 21 the potential concerns are even greater. So I

 22 think that is a great challenge and a great
 45

 1 question.

 2 CHAIRMAN GENSLER: Scott?

 3 COMMISSIONER O'MALIA: I have one

 4 question. I'd like to get a sense of how the

 5 advisory board defines high- frequency trading.

 6 You don't address it here but we've talked about

 7 high-frequency trading and I think Dr. Rudger made

 8 a good point that the speed of the markets is

 9 going much faster. Is it the general class of

 10 electronic trading and algorithmic trading and the

 11 speed of the market that is the high-frequency

 12 trading or are you specifically addressing a class

 13 of traders, the highest speed, in and out of the

 14 market, flat at the end of the day kind of group?

 15 MR. BRENNAN: That's a great and

 16 nettlesome question and for that reason we punted

 17 on attempting to define it and we in the report

 18 mention that, and I should have mentioned this

 19 when we kicked off that the issues associated with

 20 "high-frequency trading" is somewhat in the eye of

 21 the beholder we think are very real and it's

 22 collocation and it's speed and it's liquidity. So
 46

 1 we have those peppered throughout the report

 2 rather than attempt to define high-frequency

 3 trading and/or make a recommendation to the

 4 Commissions to do something about "high-frequency

 5 trading." I'll speak for myself, but I think it's

 6 the sense that I've picked up that it's here and

 7 however you define it, it's here and it's not

 8 going away so that you can get at it with

 9 policies, you can't get it as a business, nor

 10 necessarily would we recommend that but we thought

 11 it was more productive for us to try to get at the

 12 specific issues than to attempt to get the broad

 13 categorization if that's responsive to you. It's

 14 a very tough thing to categorize because each of

 15 us has his or her own definition I believe.

 16 MS. O'HARA: I would point out that I

 17 think one of the things that comes through in this

 18 report is that there isn't one group that you can

 19 point to and say they caused what happened. There

 20 are all kinds of issues in this market that have

 21 to do with speed more generally. For example,

 22 later in the report we'll talk a little bit about
 47

 1 internalizers who for the most part are not

 2 high-frequency traders by anyone's definition, but

 3 of course they are electronic in that the way

 4 markets now work is that orders are rapidly moved

 5 between venues. In my own view there are

 6 certainly issues that arise with respect to "the

 7 high- frequency traders," but I think what is

 8 missing what is the bigger point that markets are

 9 now very, very fast and it's that whole underlying

 10 speed issue that permeates a lot of the issues

 11 we're going to be talking about.

 12 COMMISSIONER O'MALIA: That is very

 13 helpful. It is my believe that overall the

 14 markets are moving much more quickly across many

 15 markets as we saw on May 6 and it's not

 16 necessarily one actor and so our solution bases

 17 are going to have to consider that as well. Thank

 18 you.

 19 MR. RUDGER: Just one point. I think

 20 it's inherent in what we've said that we are not

 21 taking the position that high-frequency trading or

 22 electronic trading is bad. That's the environment
 48

 1 in which these markets are going to exist and we

 2 need to find ways to adjust to it.

 3 CHAIRMAN GENSLER: You're saying even as

 4 the tickertape came and the telephone came, this

 5 is common and that we need to adjust. I don't

 6 know if Commissioners Walter or Chilton have any

 7 questions at this stage. I know we have three

 8 more stages.

 9 MR. BRENNAN: This is a great transition

 10 point.

 11 COMMISSIONER CHILTON: Mister Chairman?

 12 I did if that's okay. I didn't want to jump in

 13 front of Commissioner Walter, but I do have a

 14 question.

 15 CHAIRMAN GENSLER: Great.

 16 COMMISSIONER WALTER: Bart, that's

 17 perfectly fine because I don't have a question

 18 right now.

 19 COMMISSIONER CHILTON: Quickly, I think

 20 it's real clear that we do need some sort of

 21 definition because if we're going to start

 22 regulating HFTs in any different way, and our
 49

 1 statute or our rules and regulations don't contain

 2 anything on HFTs or on algos so that seems like

 3 job one is to come up -- so I agree with

 4 Commissioner O'Malia that this is an area that we

 5 need to look at, but I certainly think we need a

 6 definition.

 7 But I'm curious if the committee thinks

 8 that more needs to be done. I've raised the issue

 9 for the last several months of, one, testing

 10 whether or not some entity, and I'm not suggesting

 11 either of the Commissions, but perhaps the

 12 exchanges should test algos or what I call cheetah

 13 traders, HFT, and that's not with a Boston accent,

 14 but cheetah fast traders whether or not there

 15 should be some at least sporadic testing or sort

 16 of a Good Housekeeping Seal of Approval. CME for

 17 example has a testing environment, we had some

 18 problems with it this fall, but they would put a

 19 program into that testing environment and see how

 20 it would react. I'm curious if the advisory

 21 committee thinks that's something that would be

 22 good or is something we should explore.
 50

 1 The second part of my question is

 2 whether or not when things go array, because when

 3 they go array they go array fast with the cheetah

 4 traders, whether or not there should be some sort

 5 of accountability. We're in the middle of coming

 6 up with our antidisruptive trading practice rule

 7 and I've asked the question and our proposal asked

 8 the question whether or not we should include some

 9 sort of accountability for algos or HFTs gone

 10 wild. So I'm curious as to whether or not either

 11 of these ideas, the testing ideas or the

 12 accountability idea, make any sense to the

 13 committee.

 14 MR. BRENNAN: If I may, Chairman

 15 Gensler, if you don't mind, Commissioner Chilton,

 16 we will hold that and we will get at both of those

 17 issues explicitly in our third section if that's

 18 okay because it's right on point and right on

 19 theme. Is that fair?

 20 COMMISSIONER CHILTON: That's fair if

 21 that's what people want to do. I'm interested in

 22 the answers and whenever I get them I'm pleased to
 51

 1 hear them.

 2 CHAIRMAN GENSLER: I think, Commissioner

 3 Chilton, he's saying, yes, it happens to be part

 4 of his third piece. Is that what you're saying,

 5 Jack?

 6 MR. BRENNAN: Yes.

 7 COMMISSIONER CHILTON: Very good. Thank

 8 you.

 9 MR. BRENNAN: Let's transition, and the

 10 discussion on HFT is relevant because two areas

 11 that topic comes up in are things like collocation

 12 and access because it leads to speed. And then

 13 secondly, with respect to liquidity and

 14 obligations or not for providing liquidity

 15 behaviors that happen therein.

 16 With respect to the issues of

 17 collocation and direct collocation and direct

 18 access we have one comment and one recommendation

 19 and the fact that there only two doesn't mean

 20 these aren't vitally important issues. We think

 21 it's being addressed but we also think that you're

 22 not going back. In sum I think it's fair to say
 52

 1 you're not going to pull the teletape out.

 2 The first comment we would have is that

 3 the committee supports the SEC's Naked Access

 4 Rulemaking and we urge the SEC to work closely

 5 with FINRA and the other exchanges with

 6 examination responsibilities to develop effective

 7 testing of sponsoring broker dealer, risk-

 8 management controls and supervisory procedures.

 9 Again the SEC is there but this is evolutionary

 10 and we want to ensure that all of the appropriate

 11 oversight and controls are in place.

 12 Our second recommendation in this regard

 13 is that we recommend that the CFTC use its

 14 rulemaking authorities to impose strict

 15 supervisory requirements on designated contract

 16 markets and futures commission merchants, that

 17 employer-sponsored firms implementing algorithmic

 18 order routing strategies and that the CFTC and SEC

 19 carefully review the benefits and costs of

 20 directly restricting what are known as disruptive

 21 trading activities with respect to extremely large

 22 orders and strategies.
 53

 1 Commissioner Chilton, I think the first

 2 is I hope directly responsive to one of your

 3 questions. This whole issue as Chairman Rudger

 4 said is evolutionary, but the two areas, naked

 5 access and disruptive trading, are the two areas

 6 that we would commend to the Commission to focus

 7 most of their attention on.

 8 MR. KETCHUM: Maybe I could add one

 9 point to Commissioner Chilton's question from the

 10 perspective of my day job which is directly

 11 responsible to be looking at some of the

 12 supervision issues and the accountability firms

 13 sponsoring high-frequency traders into the

 14 marketplace on an immediate basis. I think as you

 15 can see by these recommendations, Commissioner, we

 16 think the primary responsibility from the

 17 standpoint of understanding, monitoring, testing

 18 where appropriate, should lie with the

 19 intermediaries that are responding to the market

 20 and the primary responsibility for the regulators

 21 whether that be self-regulators such as FINRA and

 22 NFA or the SEC and CFTC should be in assuring the
 54

 1 effectiveness of that supervision. I don't have

 2 enough experience to fully evaluate the CFTC's

 3 capability from a testing standpoint, but I would

 4 tell you with regard to our supervision of that

 5 now which will be greatly enhanced from the

 6 clarity of SEC rulemaking here, the range of

 7 algorithms, the sheer number, diversity and

 8 difference, is so exceptional that short of

 9 building a very narrow funnel and requiring all

 10 things to be preapproved that I think it's very

 11 difficult to maintain both competition, creativity

 12 and controls without demanding that it primarily

 13 be focused on the firms and without collectively

 14 the self-regulatory organizations and the

 15 Commissions making sure that we have extremely

 16 strict supervisory focus from this standpoint and

 17 that we continue to learn the best ways to ensure

 18 controls from that standpoint. I think our

 19 separate recommendation on disruptive trading

 20 speaks for itself, but that's our thinking and

 21 obviously we would be very interested in how the

 22 Commissions evolve as they look at this issue.
 55

 1 MR. BRENNAN: Are there comments from

 2 the committee? David?

 3 MR. RUDGER: Yes. These are mine. Put

 4 6 and 7 together. We really punted on whether we

 5 would define disruptive practices. We are leaving

 6 that to the agencies to define what they are. We

 7 didn't say in any detail what they are. And the

 8 second piece relates to the access part of it

 9 although the comment regarding broker-dealer risk-

 10 management controls and supervisory procedures

 11 relates to the access requirement. It's my

 12 opinion that that is a broader statement than just

 13 dealing with the access. That is, the

 14 broker-dealers themselves that are engaged in this

 15 practice have to have their own supervisory

 16 management controls. I hope that you'll look at

 17 this in a broader sense than just saying this is a

 18 sponsored access problem. It's the matter of

 19 having responsibility in the broker- dealer area

 20 and I think probably at the SRO area, and Rick as

 21 well to try and look at this area.

 22 MR. BRENNAN: Brooksley?
 56

 1 MS. BORN: Let me add that it seems to

 2 me that disruptive trading goes beyond access and

 3 I certainly think it's very important that there

 4 be responsible sponsored access to the market.

 5 However, I think that algorithmic trading,

 6 high-frequency trading, poses some special

 7 problems in terms of orderly trading on the

 8 markets particularly the high percentage of order

 9 cancellation I think could well be considered a

 10 disruptive trading practice that should be looked

 11 at very carefully by the Commissions.

 12 CHAIRMAN SCHAPIRO: I know I've talked

 13 about the need for some kind of throttles on order

 14 execution algorithms and it's a lot easier to say

 15 I think than it is to do and that it's a question

 16 of who's in the best position to do it and that's

 17 likely going to be industry and not regulators.

 18 But I wondered if there are unintended

 19 consequences from the mere existence of throttles

 20 that operate under varying market conditions that

 21 we should be thinking about if we go down this

 22 path.
 57

 1 MR. BRENNAN: We have some in our next

 2 set of recommendations. We get at some

 3 market-based recommendations. The recommendations

 4 presume there's nothing malevolent going on and

 5 disruptive trading has a different connotation,

 6 but we have some I think pretty I hope interesting

 7 and probably provocative capitalistic solutions in

 8 here which will be throttles, could be speed bumps

 9 but we hope will get at that. I'd be happy to

 10 take other questions. This is a short section.

 11 We could use that as the catalyst to move on or

 12 take questions, Chairman Gensler, from anyone on

 13 these topics.

 14 CHAIRMAN GENSLER: Commissioner O'Malia?

 15 COMMISSIONER O'MALIA: Commissioner

 16 Born, you mentioned consequences, pretrade

 17 functionality and some of these speed bumps or

 18 access requirements is one means of setting up

 19 best practices or a standard. Did the advisory

 20 committee consider any consequences if there are

 21 breached or solutions for punishment?

 22 MS. BORN: The subcommittee on which I
 58

 1 was I don't think considered that issue. I don't

 2 know if the other subcommittee did or not.

 3 MR. KETCHUM: We weren't particularly

 4 focused on consequences, we think that's probably

 5 best approached by the regulatory agencies, but we

 6 took notice to the fact that both of the agencies

 7 and FINRA and the NFA have the authority to the

 8 extent that firms, and I want to completely agree

 9 with Brooksley, that this is focused both on

 10 firms' proprietary algorithmic trading as well as

 11 their sponsorship. If you look at the

 12 recommendations, it focuses on both employ or

 13 sponsor. We think that the existing disciplinary

 14 tools that exist from the standpoint of those

 15 firms sponsoring in will allow significant ability

 16 to demand and to have consequences from the

 17 standpoint of fines or even limitation of

 18 business. The separate question as to whether the

 19 Commissions look to have those consequences on

 20 persons who are not registered and beyond the

 21 responsibility of the SROs I think is best left

 22 with the Commissions.
 59

 1 CHAIRMAN GENSLER: I apologize. I was

 2 going to let you go on but then I noticed on

 3 recommendation 7 you mention sponsorship, not

 4 sponsorship, about supervision and requirements

 5 when you talk about designated contract markets

 6 and futures commission merchants. In this new

 7 world of swaps I know it's not there, but is the

 8 absence of swap execution facilities because you

 9 had to pull this together and you hadn't put it in

 10 or was there a conscious that there's only and not

 11 the other?

 12 MR. KETCHUM: The first is correct. Our

 13 focus wasn't primarily on the over-the-counter

 14 derivative market and we watched with interest and

 15 exhaustion the rules that the two Commissions are

 16 required to continually put out from the

 17 standpoint of SEFs, swap dealers, exchange markets

 18 and the rest. But, no, I personally agree with

 19 your logic. We're looking for controls across

 20 responsible entities and entities that the two

 21 Commissions impose regulatory responsibilities on

 22 so we focus it as simply not a focus but not an
 60

 1 attempt to suggest that they shouldn't have that.

 2 MR. BRENNAN: The next section is about

 3 liquidity and obviously liquidity is the key to

 4 the robustness and the integrity of our markets in

 5 many, many ways so that we have five

 6 recommendations that we would put forth to you

 7 dealing with that topic the first of which is that

 8 the SEC evaluate the potential benefits which

 9 might be gained by changes in make or take your

 10 pricing practices through building in incentives

 11 for the exchanges to provide for peak load pricing

 12 models and we'll expand on that a little bit once

 13 we get through this list. It's a creative idea.

 14 The committee's second recommendation is

 15 that the SEC evaluate whether incentives or

 16 regulations can be developed to encourage persons

 17 who engage in market-making strategies to

 18 regularly provide buy-and-sell quotations that are

 19 reasonably related to the market. Again it's a

 20 modern era recommendation given how markets have

 21 evolved. The third recommendation in the broad

 22 category of liquidity is that the SEC and CFTC
 61

 1 explore ways to regulate excess order

 2 cancellations and we've touched on that a little

 3 bit already, including possibly requiring a

 4 uniform fee across all exchange markets that is

 5 assessed based on the order cancellations to

 6 actual transactions effected by the market

 7 participant. Again in our open meetings you heard

 8 that cancellations were seen to be a major issue.

 9 The fourth recommendation in this

 10 category is that the SEC conduct further analysis

 11 regarding the impact of a broker-dealer

 12 maintaining privileged execution access as a

 13 result of internalization in internalizing its

 14 customers' orders or through preferencing

 15 arrangements. It's our hope that the SEC review

 16 would at a minimum consider whether first it

 17 should adopt its rule proposal regarding the

 18 internalized and preferenced order flows only be

 19 executed at a materially superior, and we make a

 20 for instance of 50 mills for most securities to

 21 the quoted best bid or offer. A second area to

 22 focus on would be requiring firms internalizing
 62

 1 customer order flow or executing preferenced

 2 orders flow to be subject to market-maker

 3 obligations that require them to execute some

 4 material portion of their order during volatile

 5 markets, staying in the market.

 6 The final recommendation in the broad

 7 category of liquidity is that we recommend that

 8 the SEC study the costs and benefits for

 9 alternative routing requirements. In particular

 10 we recommend that the Commission consider adopting

 11 a trade-at routing regime. The committee further

 12 recommends analysis of the current top of book

 13 protection protocol and the costs and benefits of

 14 its replacement with greater protection to limit

 15 orders placed off the current quote or increased

 16 disclosure of relative liquidity in each book.

 17 Again in the early stages together, this whole

 18 topic of liquidity, where it went, what was real

 19 and what was ephemeral was so important that this

 20 is a core part of our recommendations. Rob, could

 21 I ask you to expand a little bit on that first

 22 one? I think it would be very helpful for the
 63

 1 Commissioners and the audience to hear some

 2 thoughts about that.

 3 MR. ENGLE: I think the most dramatic

 4 thing that we saw on May 6 was the evaporation of

 5 liquidity and so liquidity is a natural topic for

 6 us to be focused on and to some extent our

 7 proposals deal with liquidity in a crisis and also

 8 liquidity in general for the markets. In the old

 9 days, liquidity flowed into the markets when there

 10 was turbulence in the market because the

 11 market-makers could profit from the bid-ask spread

 12 which would get naturally considerably wider and

 13 the spread was more or less a market mechanism for

 14 determining who was going to supply liquidity and

 15 who was going to demand liquidity and that kept

 16 this in balance. I think in the electronic world

 17 where things move so fast and the spread never

 18 gets much wider, this incentive to supply

 19 liquidity when markets become more turbulent is

 20 diminished and I think the idea that we have in

 21 this proposal is that perhaps we need a better way

 22 to encourage liquidity particularly as markets
 64

 1 become more turbulent. We've proposed in here one

 2 mechanism but there would be probably lots of

 3 alternatives that could be used, but the idea is

 4 that it should be a time-varying incentive to

 5 supply liquidity, that sometimes when it's really

 6 important that liquidity be encouraged and that's

 7 where the peak load pricing idea comes in like you

 8 charge a different price for electricity when air

 9 conditioners are all turned on than you do when

 10 it's cool outside. The proposal here would be to

 11 do it with maker-taker pricing arrangements so

 12 that there is an access fee for taking liquidity

 13 and a liquidity rebate for supplying liquidity.

 14 This is set up by Reg NMS, and in fact rebates are

 15 not limited but the access fee is limited and

 16 these are typically set by individual exchanges

 17 and they are constant over time. So the question

 18 is could they really be set in a time-varying way

 19 and I think one of the things that would be an

 20 easy, simple step might be just to remove the

 21 ceiling on access fees at times when the market is

 22 short of liquidity, that that would allow
 65

 1 exchanges to raise their access fees which would

 2 discourage new orders from coming in to take

 3 liquidity and hopefully they would at the same

 4 time increase the rebate because they tend to

 5 offset each other in terms of the P&L of the

 6 exchange and to encourage liquidity supply. The

 7 hope would be that a time like this would give the

 8 market incentive to solve illiquidity issues

 9 before we hit either the limit-up/limit-down or

 10 the pauses that we've already talked about. Since

 11 this would be up to each individual exchange's

 12 discretion, of course you have to think about how

 13 competition across exchanges would work out. But

 14 it seems to me that if one exchange has a higher

 15 access fee than another, they're going to get

 16 fewer aggressive orders coming so that that would

 17 mean that the aggressive orders would all be

 18 flowing to an exchange which had a lower access

 19 fee and correspondingly this might suggest that

 20 they might also want to raise their access fee,

 21 and similarly if liquidity is flowing to exchanges

 22 where the rebate is higher, then their book would
 66

 1 fill up more quickly and so there would be natural

 2 reasons why exchanges would compete in both the

 3 access fee and the rebate. It I think could be

 4 done relatively simply, although the question of

 5 whether algorithms would be rewritten and how they

 6 would learn that you turned off this fee and

 7 exchanges would take the effort to change the

 8 fees, I don't know how well that would work.

 9 MR. BRENNAN: Before we go to questions,

 10 I thought it might be helpful to have Maureen talk

 11 a little bit about our last recommendation as well

 12 for further definition.

 13 CHAIRMAN GENSLER: Which number is it?

 14 MS. O'HARA: Number 12. I'd like to

 15 pick up on what Rob has started, that the issue

 16 that we're focusing on here is that markets

 17 provide both price discovery and liquidity. A lot

 18 of the ways that we traditionally thought about

 19 markets have focused on enhancing the price-

 20 discovery, so you can think about things like the

 21 consolidated tape and NBBO has other features that

 22 help you understand where the price is at any
 67

 1 particular point in time. The challenge we now

 2 have is that liquidity is also something produced

 3 in markets, but in a fragmented world and in a

 4 world where liquidity moves not only across equity

 5 markets but across to different types of contracts

 6 such as futures and options, the nature of

 7 liquidity is not homogeneous. So part of the

 8 challenge that you face is that liquidity now is

 9 not as Rob pointed out being provided by a

 10 designated person who sets an amount they'll buy

 11 and sell and there's liquidity. Liquidity now is

 12 created through a conglomeration of orders being

 13 willing to buy or sell on limit order books and

 14 the challenge you have is you have to incent

 15 people to be willing to post liquidity because if

 16 they don't do it, books become empty and we saw

 17 what happens when that occurs.

 18 The key to recognizing the challenge

 19 here is to recognize that all liquidity is not the

 20 same. A lot of the orders that flow into the

 21 market particularly retail orders and equities are

 22 generally reviewed as benign orders. They're
 68

 1 generally not information related, the orders that

 2 market-makers generally expect in the old days

 3 they'd make money off of and allow them to bear

 4 the losses they get from more toxic order flow.

 5 The challenge you now have is that in a world with

 6 the trade-through rule, you have to match the top

 7 of the book, you have to match the best quote or

 8 send the order to where it's going. The ability

 9 to match the best quote and not send the order

 10 does two things. It does allow the person whose

 11 order has been sent in who wants to trade to get

 12 the best price quote that's in the market, but

 13 they're getting potentially for example from the

 14 internalizer and not from the person who actually

 15 posted that best quote up front. The problem with

 16 that is that it doesn't give the right incentives

 17 to post a quote, it doesn't give the right

 18 incentives for liquidity provision and that's

 19 really what we're trying to focus on, how do we go

 20 about creating a world in which liquidity

 21 provision arises naturally in market?

 22 The current structure of how routing
 69

 1 occurs contributes both to the market that works

 2 extremely well and to a market that may not work

 3 extremely well because one of the challenges now

 4 is that large amounts, some might even argue

 5 almost all, retail order flow never makes it to

 6 the actual market but instead is caught in various

 7 types of internalizing types of processes and

 8 that's created a very competitive market which is

 9 a very good thing, but it also has created this

 10 quote-matching challenge that discourages limit

 11 order.

 12 The other problem we currently have is

 13 that limit order protection applies to the top of

 14 the book but not below and one of the challenges

 15 we discovered was orders routed to markets that

 16 had the top of the book but very little below and

 17 those orders just fell to the bottom. What we are

 18 advocating now is to recognize that essentially

 19 the highway that orders travel on is a lot more

 20 complicated and that we have to continue to think

 21 about how in a market that's as fast as this one

 22 do you give the right incentives to post liquidity
 70

 1 and that is behind our recommendation, the notion

 2 of moving to a trade-at from trade-through might

 3 be a good rule for the Commissions to consider.

 4 We note however that it is a huge recommendation

 5 in many, many ways because the markets have been

 6 built with the structure that was put in place as

 7 you will not only through Reg NMS but previous

 8 decisions and we don't indicate that we think this

 9 is an easy change. But we do recognize that we

 10 have to think more seriously about the nature of

 11 incentives to post liquidity and Rob's suggestion

 12 about changing access fees is one, and this

 13 suggestion about rethinking routing decisions is

 14 another.

 15 CHAIRMAN GENSLER: I suspect Chairman

 16 Schapiro and Commissioner Walter might have some

 17 questions.

 18 MR. BRENNAN: We did disclaim it as

 19 provocative just to be clear.

 20 CHAIRMAN SCHAPIRO: It is, but trade-at

 21 is something that I've been interested in for a

 22 long time so I would be curious that beyond you do
 71

 1 acknowledge that there are substantial costs with

 2 respect to technology and implementation with

 3 going to something like a trade-at rule, but are

 4 there other potential downsides from it?

 5 MS. O'HARA: I think part of the

 6 challenge that you have is I think the

 7 trade-through rule created a very competitive

 8 market which has been a great thing. We have

 9 large numbers of participants in markets now and

 10 as you well know, you are now regulating 13

 11 exchanges and myriad off-exchange venues to trade.

 12 Not all nonexchange settings should be affected by

 13 this. There are lots of ways the market has

 14 evolved to more efficiently handle orders. But

 15 certainly part of the way markets work these days

 16 with orders shifting back and forth might be

 17 affected by trade- at and that might affect the

 18 business models of a number of firms in the

 19 markets. This is not a trivial change and as we

 20 say, one factor that does enter into our thinking

 21 is the behavior of the internalizers as portrayed

 22 in the wonderful reports that staff pointed out
 72

 1 that they produced that a lot of the

 2 internalization which normally does take this

 3 order flow and clears it before it gets to the

 4 rest of the market stop doing that and instead

 5 route it at that point so that there have been

 6 costs and benefits to the structure that we have

 7 and there are undoubtedly large costs and benefits

 8 that will apply here. The issues that I think the

 9 Commissions will have to struggle with is whether

 10 the costs on liquidity provision that we're

 11 currently with are sufficiently large to outweigh

 12 what will be huge costs for a number of technology

 13 issues, for business and for the interactions

 14 between different participants in the market.

 15 MR. BRENNAN: Are there other comments

 16 from the committee on any of these

 17 recommendations?

 18 MS. PHILLIPS: I think that as we were

 19 struggling with this we were trying to keep the

 20 emphasis on provision of incentives and

 21 recognizing that as soon as you define a rule or a

 22 category of traders, traders then realign their
 73

 1 businesses to get outside of the definition so

 2 that you can sort of get into a quagmire or a trap

 3 and that was why we were trying to focus on

 4 provision of liquidity so that as all kinds of

 5 regulations are being considered, thinking in

 6 terms of does this create additional incentives

 7 for liquidity so that that was trying to keep the

 8 point on the incentive.

 9 I think that from an economist's

 10 perspective the notion of perfect markets, of all

 11 orders being exposed to all other orders, we're

 12 not turning back the clock here. We know that's

 13 not going to happen. But recognizing that lots of

 14 new players are coming to the market and that the

 15 high-frequency trading, computerized trading,

 16 algorithms, so on, are changing the complexity and

 17 the types of people who are coming to the markets

 18 that it is worth a relook at some of these basic

 19 questions of such things as internalization. We

 20 know we're going to have internalization, but the

 21 question is to have the right amount of it so that

 22 it's not denigrating the pricing mechanism that
 74

 1 you hope markets will provide. It is a balancing

 2 and that's why it is true that we didn't focus as

 3 much on trying to be very precise with the

 4 definitions because we know as soon as you do

 5 that, somebody is going to try to get outside of

 6 that, but keeping the eye on the ball of

 7 confidence in the markets, liquidity, and as soon

 8 as markets lose credibility they're gone and if

 9 you get too much pricing away from the markets are

 10 you losing that price-discovery function which is

 11 so very important? That's why we kept coming back

 12 to the questions of liquidity provision.

 13 MR. BRENNAN: Brooksley?

 14 MS. BORN: Let me mention that to the

 15 extent that precipitous withdrawal of liquidity by

 16 for example high- frequency traders, through

 17 algorithm trading or when disproportionate order

 18 cancellation occurs, I think that it is possible

 19 to consider that a disruptive trading activity and

 20 therefore the Commissions can consider regulation

 21 as well as incentives as a tool and that's one of

 22 the reasons why for example in recommendation 9 we
 75

 1 mention both incentives or regulations.

 2 CHAIRMAN GENSLER: I find myself

 3 associating with so many comments but, Susan, I

 4 liked how you said confidence in liquidity and the

 5 pricing function of markets and that too much is a

 6 way and that's a problem. On order cancellations

 7 and Commissioner Dunn and were chatting here so

 8 maybe I'm taking part of his question, but many of

 9 these markets have very high numbers of

 10 cancellations per order. In rapidly changing

 11 markets some of them are 100 orders for every

 12 transaction or more and I wouldn't be surprised if

 13 5 years from now when Watson will seem old and

 14 there will be something new. When Mike Dunn

 15 started at the Commission, Watson wouldn't have

 16 won. Big Blue didn't win. But as for this order

 17 cancellation, give us a little bit more thinking I

 18 guess it was on recommendation 9 or 10.

 19 MR. KETCHUM: Maybe I can start it and

 20 then look to my fellow committee members. I think

 21 it's very important to parse the actual words of

 22 the recommendation and to remember back to the
 76

 1 important statements made by many, but Jack in

 2 particular. It was not the committee's intention

 3 to make a judgment of the appropriateness of a

 4 particular type of trading and that I think is

 5 consistent across the entire set of

 6 recommendations. Recommendation talks about the

 7 Commissions exploring ways to fairly allocate the

 8 cost imposed by high levels of order calculations

 9 including perhaps a uniform --

 10 CHAIRMAN GENSLER: So that's just

 11 allocating costs and not prohibiting?

 12 MR. KETCHUM: If one looks across more

 13 concentrated market structures particularly I'll

 14 speak to the one I'm most familiar with which is

 15 the fragmented equity markets in the United

 16 States, if you look across concentrated order

 17 structures you will generally see that there are

 18 provisions either relating to throttling orders or

 19 imposing costs from the standpoint of huge levels

 20 of message traffic where the huge levels of

 21 message traffic are not terribly related to the

 22 number of executions that occur from the message
 77

 1 traffic. There can be instances and we're very

 2 focused where that can be improper. It is a

 3 judgment that those impose very substantial costs

 4 from the standpoint of technology, capacity and

 5 surveillance. The recommendation is really

 6 focusing on recognizing that in a very fragmented

 7 world, candidly the exchanges who might otherwise

 8 impose a variety of restrictions have no leverage

 9 whatsoever in providing it. So the focus I'd aim

 10 it on is the precise words of fairly allocating

 11 costs.

 12 COMMISSIONER DUNN: If I could follow-up

 13 on that, Richard, because you are very precise in

 14 what you're saying when you said it deserves

 15 further study. I guess we're looking at what

 16 areas should we look at to study further. Is the

 17 cancellation fee primarily on the bid side or ask

 18 side? You say that the CFTC should evaluate

 19 whether it is something we ought to adopt as well.

 20 Are they allocated X number of cancellations that

 21 they can have and should that carry across from

 22 venue to venue?
 78

 1 MR. KETCHUM: I think those are very

 2 good questions. That's one of the reasons we're

 3 pleased to be the advisory committee. Including

 4 both agencies is not to say that both markets or

 5 the range of markets are in identical

 6 circumstances or that the precise response given

 7 the different circumstances should be the same.

 8 Nor again as I say is it a suggestion that there

 9 should be an allocation of message traffic or

 10 cancellations. I don't think anything here would

 11 suggest that type of rationing. It is to suggest

 12 that it's worth exploring the demonstrable impact

 13 from a cost standpoint this has and evaluating the

 14 best way to address it. I will say that we are in

 15 the business of conducting surveillance and we

 16 find it is notable that in many instances the

 17 range of cancellations in more inactive stocks

 18 seem to have no great economic rationality from

 19 any trading strategy. As you move to more active

 20 stocks the rationality becomes very clear and it

 21 really becomes a question of allocation. The

 22 right answer is not necessarily the same across
 79

 1 different regulatory marketplaces and we are very

 2 careful in suggesting it be considered because we

 3 don't view this as simple at all. We are all

 4 believers in both Commissions' efforts to provide

 5 low barriers to entry and encourage competition

 6 and we think that the Commissions are the right

 7 ones to be able to make these judgments.

 8 COMMISSIONER DUNN: I think you quite

 9 accurately point out that a single exchange can't

 10 do this because they don't have the broad view of

 11 everything. Is this something that falls under

 12 FINRA's oversight or is it something that the

 13 Commissions ought to have that data or that

 14 information available to make some judgments on

 15 what's going on?

 16 MR. KETCHUM: I personally think

 17 speaking of the equity markets that the only

 18 appropriate place for it to begin is with

 19 Commission participation because it certainly

 20 can't work unless there is a consistency across

 21 all liquidity-providing markets that compete

 22 against each other on the equity side and I'll put
 80

 1 separately the question of futures. I do think

 2 that while it might involve FINRA and exchange

 3 rulemaking, it certainly should begin with the SEC

 4 and I would expect that the answer is the same on

 5 the CFTC side.

 6 CHAIRMAN SCHAPIRO: I want to follow-up

 7 on that. It strikes me based on a several of you

 8 have said that there are a lot of different

 9 combinations of fees and rebates that could be

 10 combined to different effect in the market and one

 11 of the ones that occurs to me is if you have an

 12 order cancellation fee whether you would waive

 13 that fee or reduce that fee to market participants

 14 who undertook to provide liquidity. Is that a way

 15 for us to think about some of these things is we

 16 very much I guess need to think about how they

 17 work together and what the implications or doing

 18 one or waiving one or increasing one or lowering

 19 one is in combination with all the other potential

 20 responses?

 21 MR. BRENNAN: I think that's exactly the

 22 right analysis, that there is a theme and part of
 81

 1 what would be the end objective as a practitioner

 2 would be to see behaviors that you want based on

 3 the various incentives and mechanisms in place.

 4 It's partly, Chairman Schapiro, why we wanted to

 5 bunch these together in presenting them to you

 6 under a packaging so that they fit together and

 7 not stand alone.

 8 MR. ENGLE: I think one of the things

 9 that I think we could worry a little about with a

 10 fee on cancellations relates more or less to this

 11 point which is the orders that are being cancelled

 12 are actually sitting limit orders so that they are

 13 already liquidity supply, so by charging for

 14 cancellations you're making it somewhat more

 15 expensive for liquidity to be supplied and I think

 16 this is a counter-incentive to the liquidity

 17 supply that we're interested in. My feeling is

 18 that it's really the real cost of all the message

 19 traffic that we should charge for rather than some

 20 distortion in the market that comes from

 21 cancellations themselves. I don't know how you

 22 measure exactly the real cost, but if it's not
 82

 1 high now, it's going to get high soon and sooner

 2 or later there needs it seems to me to be a charge

 3 for the message cost but I think it might not be a

 4 positive effect on liquidity supply unless you do

 5 something different for people who are designated

 6 market makers or something like that as you

 7 suggested.

 8 MR. BRENNAN: David?

 9 MR. RUDGER: I'd like to comment on

 10 number 9 where the phrase that is used is "engage

 11 in market-making strategies," and then you asked

 12 to provide buy and sell quotations that are

 13 reasonably related to the market. It might be

 14 possible to expand that recommendation to say

 15 require some obligation to provide liquidity.

 16 It's not in there and I might have wanted to have

 17 it in there. The other piece of this is that the

 18 phrase "engage in market- making strategies" is

 19 not very well defined and I at least was concerned

 20 as to whether those who are engaged in collocation

 21 are somehow engaged in market-making strategies

 22 and whether that's an appropriate activity that
 83

 1 might be looked at in terms of imposing additional

 2 responsibilities.

 3 MR. KETCHUM: Perhaps one clarification.

 4 The committee in using those words used them not

 5 in the traditional registered market-maker concept

 6 but more in the concept that was used by staff in

 7 their studies that you provided us that identified

 8 market-making strategy and market-making like

 9 activity. I think I fairly state that addressing

 10 all that is easy from that standpoint. We

 11 definitely did not mean to constrain it to the

 12 existing market makers and supplemental market

 13 makers who exist in markets today.

 14 CHAIRMAN GENSLER: Jack, do you want to

 15 do the fourth area unless Commission Walter or

 16 Commissioner Chilton and particularly Commissioner

 17 Walter since so much of this is on the SEC side?

 18 COMMISSIONER CHILTON: I do have another

 19 question, Mister Chairman, if now is appropriate.

 20 CHAIRMAN GENSLER: Yes.

 21 COMMISSIONER CHILTON: I'd like to ask

 22 Chairwoman Born a follow-up. She was talking
 84

 1 about disruptive practices and HFTs and that was

 2 as you recall one part of my earlier question. I

 3 feel like maybe you guys punted a little bit on

 4 this question so that I'm curious if there is a

 5 little more granular thought that Chairwoman Born

 6 has. If there is no law, rule or regulation that

 7 differentiates between practices that

 8 intentionally go in and that are maybe risky

 9 trading strategies but that they roil markets, but

 10 were just a risky trading strategy, and then

 11 strategies that are designed to roil markets, even

 12 to go so far as financial terrorism. If we don't

 13 as regulators set up a line between what these

 14 things are and have some accountability, what is

 15 there to stop people from engaging in them? I'm

 16 not suggesting that we mess up something that's

 17 positive out there. If this cheetah trading, this

 18 FHT trading -- narrow spreads and increases

 19 liquidity, that's great. My concern is that these

 20 activities by these

 21 artificial-intelligence-generated systems disrupt

 22 efficient and effective market. So I'm curious,
 85

 1 Brooksley, if you had a further thought on that.

 2 MS. BORN: I think you're pointing out

 3 some very relevant issues and although I plan to

 4 support the report of the advisory committee, I

 5 would have been pleased to see a more forceful

 6 recommendation that both Commissions investigate

 7 and consider the issues raised by high- frequency

 8 trading, massive order cancellation and related

 9 issues as disruptive trading activities and

 10 consider the possibility of regulations that would

 11 limit them. Obviously the report that we're

 12 submitting doesn't go that far. I would have been

 13 pleased if it did.

 14 MR. KETCHUM: If I could add one

 15 clarifying thing, Commissioner Chilton, to

 16 Chairwoman Born's comments. I don't think you

 17 should have any doubt at least speaking from the

 18 equity side that intrusions aimed at denial of

 19 access or intentionally destabilizing the markets

 20 are at a minimum violation of exchange and FINRA

 21 rules and I think actually the Commissions would

 22 find way for it to be a violation of theirs, but
 86

 1 at a minimum they're violations of FINRA and

 2 exchange rules. The terrorism suggestion, I don't

 3 want there to be confusing anyone on this call

 4 that that is illegal today in the equity markets

 5 and clearly so, putting aside the question of what

 6 we think is value of the Commissions continuing to

 7 focus on the broader issues that Chairwoman Born

 8 properly described that could be considered.

 9 MR. STIGLITZ: May I make one comment?

 10 I very strongly endorse what Chairwoman Born has

 11 just said. I too would have liked a stronger

 12 statement along those lines.

 13 MS. BORN: Let me point out a sentence

 14 that gives me some comfort in my decision to

 15 support the report, and that is on page 11 when

 16 it's talking about order cancellation. In the

 17 text recommendation number 10 it says, "At a

 18 minimum we believe that the participants of those

 19 strategies, that is order cancellation, should

 20 properly absorb the externalized costs of their

 21 activity." I do think that both Commissions are

 22 free to and should in my view look at whether
 87

 1 further action by the Commissions is needed.

 2 CHAIRMAN GENSLER: I want to note that

 3 committee member Stiglitz is on. I think that's

 4 terrific. I didn't realize that you were so I

 5 apologize, Joe, that I didn't earlier introduce

 6 you as well. I do sense that on this issue of

 7 when do order flows and messaging get so large

 8 that they by their very nature and not just a cost

 9 but are disruptive is one that this committee

 10 maybe hasn't come together on yet, but it would be

 11 helpful to understand. When is it so much that

 12 it's again not just a cost, but it may well be

 13 either intentionally or some other way disruptive?

 14 I think that's what we're hearing.

 15 MR. KETCHUM: And we're committed to

 16 continue that discussion in the ongoing weeks.

 17 MR. RUDGER: I'd like to say that I

 18 agree with Chairman Born on this issue. I had

 19 thought that her concepts were caught with our

 20 recommendation that the Commissions look at what

 21 is disruptive trading and that those as she

 22 described them would be logically one of the areas
 88

 1 of inquiry.

 2 MR. BRENNAN: I think that's right,

 3 David. In response to your question, Gary,

 4 without making them defined terms we were hoping

 5 that we could as Rick said as we continue our work

 6 get to just the question you were asking and we

 7 hope that that board bucket of disruptive trading

 8 would address some of this.

 9 I know we're pressed for time so I want

 10 to bring us home in the last lap of the Daytona

 11 500 with a broad topic, and obviously the last

 12 bucket of topics for us was information and

 13 markets and regulatory responsibilities are

 14 nothing but information in many ways. We had two

 15 here that we thought were most important to

 16 recognize and in some ways to endorse some work

 17 that's gone on. The first is that we recommend

 18 that the Commissions, and you can see why given

 19 what we've been discussing today, consider

 20 reporting requirements for measures of liquidity

 21 and market imbalance for large market venues. One

 22 of the underlying themes here is what is real
 89

 1 liquidity and what is notional liquidity so that

 2 we would encourage each of you to look and see if

 3 there are ways that you can help market

 4 participants know better what the market dynamic

 5 looks like.

 6 Our last recommendation follows on SEC's

 7 work and we recommend that the SEC proceed with

 8 two caveats, one, with a sense of urgency. We

 9 think that it's required to move quickly. And a

 10 focus on cost-benefit to implement a consolidated

 11 audit trail for U.S. equity markets. We know that

 12 that's an area of great interest to Chairman

 13 Schapiro. The sense of urgency and cost-benefit

 14 are linked. We believe that it's beneficial for

 15 us to move ahead with whether we need real time or

 16 we think getting into that game, if you will,

 17 quickly is important. We think May 6 was a great

 18 example and the follow-on from May 6 was a great

 19 example of how beneficial that consolidated audit

 20 trail could be and in some ways not to let

 21 perfection be the goal since we're not sure what

 22 that is. My assistant asked that the CFTC should
 90

 1 similarly enhance its existing data collection

 2 regarding orders and executions. Chairman

 3 Gensler, I didn't mean to short-change you on that

 4 recommendation. It's the last recommendation but

 5 hopefully each of the Commissions understand why

 6 we believe that data enhancement is so important

 7 to you but also to the markets generally. That

 8 concludes our recommendations and we'd obviously

 9 take questions.

 10 CHAIRMAN GENSLER: We have questions

 11 from Commissioner O'Malia and also at some point,

 12 I don't know if there may be staff questions.

 13 COMMISSIONER O'MALIA: Thank you. Two

 14 questions. Fourteen does capture a challenge

 15 ahead of us and if you could elaborate on any

 16 thoughts you have. In putting this study together

 17 and looking at the events of May 6, what were the

 18 data issues that most confounded your work and

 19 presented challenges to you at least in our

 20 markets and in the futures markets? Second, would

 21 it help in defining the original question I asked,

 22 that is, if we had mandatory markers on specific
 91

 1 traders by activity?

 2 MR. KETCHUM: I think it's an excellent

 3 question, Commissioner O'Malia. I'll speak again

 4 from my experience in surveilling the equity

 5 market, but that's certainly an excellent question

 6 for the futures market as well. I believe both

 7 markets are limited by the limited granularity and

 8 details of the audit trail information that it has

 9 immediate access to. The SEC has a separate

 10 problem from the standpoint of needing to be as

 11 the Commission properly notes in its consolidated

 12 audit trail to be directly linked into that

 13 information which is pretty much manipulated by

 14 the exchanges and FINRA today.

 15 CHAIRMAN SCHAPIRO: Manipulated in a

 16 good way, not manipulation-manipulation.

 17 MR. KETCHUM: Cared for. Thank you.

 18 But there is a clear lack of granularity given the

 19 fact that electronic traders today are very

 20 involved in pricing the marketplace and the

 21 systems have been not completely with respect to

 22 large traders and a variety of things, but have
 92

 1 been primarily focused on the persons who are

 2 registered who have traditionally been the pricing

 3 mechanism for the marketplaces. I think you're

 4 right and I think not only as obviously terribly

 5 critical in the equity to ensure to have that

 6 information be consolidated across fragmented

 7 markets, but also that it easily allows the

 8 Commissions and the self-regulators to confidently

 9 look at the persons who are impacting the market

 10 and to do that in a short period of time and not

 11 have the difficulty of pulling that information

 12 together over considerably longer periods of time.

 13 I think it's not just consolidated, it's also

 14 granularity and your question is very correct.

 15 MR. BRENNAN: Are there other opinions?

 16 David?

 17 MR. RUDGER: I would like to urge both

 18 Commissions to coordinate their audit trail

 19 responsibilities because we're talking a market

 20 here in which traders are trading both the futures

 21 market and the stock markets, equity markets, and

 22 it would be important to have I think some
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 1 identified marker so you could trace the

 2 activities of any particular individual trader in

 3 both markets.

 4 CHAIRMAN GENSLER: So that I understand,

 5 Commissioner O'Malia when you were using the word

 6 marker were you using it as David was, a sort of

 7 unique identifier by trader? Is that what you

 8 were asking?

 9 COMMISSIONER O'MALIA: I actually asked

 10 that question and I'm interested in general what

 11 would it be, but by behavior.

 12 CHAIRMAN GENSLER: Consistent maybe with

 13 what Commissioner Chilton was saying too.

 14 COMMISSIONER O'MALIA: Do we need to by

 15 their trading style or behavior?

 16 CHAIRMAN GENSLER: So that's the

 17 question. Do you think we should have any I.D.'s

 18 by style or behavior? I see shrugs. I think I'm

 19 getting a no.

 20 MR. KETCHUM: From a cost-benefit

 21 standpoint I think that there may be great value

 22 in focusing on the most active participants in the
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 1 market. I don't know whether I would describe

 2 them precisely by behavior, but I.D.'s for every

 3 participant in the market creates a great deal of

 4 complexity that don't necessarily provide as much

 5 as regulatory benefit as it could. From that

 6 standpoint and focusing particularly on not just

 7 persons with large positions but persons who are

 8 extremely active in the market, I think that's a

 9 good distinguishing factor. I don't know whether

 10 I'd go further than that.

 11 CHAIRMAN GENSLER: Again back to the

 12 phone from your side, Joe Stiglitz or Commissioner

 13 Chilton or Commissioner Walters?

 14 MR. STIGLITZ: I feel comfortable. The

 15 only one other thing I might want to add and

 16 you'll get the spirit is as I always do is the

 17 link between some of the concepts that keep

 18 getting raised like price discovery and the real

 19 economy. Price discovery in a microsecond or a

 20 nanosecond may have no real relevance or very

 21 limited relevance to the economy and therefore

 22 some of the other issues that have been raised
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 1 about the cost have to be balanced with the

 2 questionable issues about the benefits.

 3 CHAIRMAN GENSLER: I don't know that

 4 there are, but are there any questions from Robert

 5 Cook from the SEC team or Andrei and Steve from

 6 the CFTC team? Robert? You might want to get up

 7 to a mike so that the public can hear you.

 8 Robert, they're handing you a mike.

 9 MR. BRENNAN: His question was to

 10 amplify on recommendation 13 and what kind of

 11 information and what uses of that information we

 12 would suggest you make.

 13 MS. O'HARA: We had discussions about

 14 these issues in the sense that part of the

 15 challenge you now see is that the information

 16 environment that surrounds a highly fragmented

 17 world in which liquidity is scattered across many

 18 markets creates real difficulties for the market

 19 to figure things out let alone for the regulators

 20 to figure things out so that recommendation 13 is

 21 really trying to think about what is the

 22 information need in a world that's so fast and so
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 1 fragmented? Part of the challenge that see is

 2 that professional traders now really don't rely on

 3 the consolidated tape because it doesn't meet

 4 their needs. They buy information from the

 5 various trading venues to help them for example

 6 construct measures of the book so that they have a

 7 better idea of where liquidity exists in these

 8 markets.

 9 I think that raises a broader question

 10 about whether or not the market more generally,

 11 not just people who buy it from proprietary

 12 trading feeds, need greater information on markets

 13 and the issues that we're trying to address here

 14 go back again to the fact that our information

 15 provision in the past has been more related to the

 16 notion of price discovery and less perhaps to

 17 liquidity that underlies that price discovery.

 18 Issues here for example could be measures of the

 19 amount of depth that exists in any particular

 20 market setting. I think one of the things that is

 21 particularly fascinating about the report that the

 22 staffs provided was the insight that the book on
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 1 the CME's e-mini was becoming empty for hours

 2 before the actual crash and that's a fascinating

 3 statistic. Had the market had an idea of how

 4 imbalanced the orders were, it might have led to

 5 more willingness to run in and provide orders on

 6 the empty side. Part of what we're recommending

 7 here and I admit it's rather vague but it is

 8 focusing on this idea that liquidity now is not a

 9 given. It's going to come about through the

 10 accumulation of orders on books and through the

 11 incentives to get people to send orders to these

 12 markets. They won't know to send if they don't

 13 really know what the nature of the liquidity is.

 14 There is a downside that we talked about

 15 and that is you don't want to scare people. You

 16 don't want to say them, by the way, over here

 17 there is really nothing but sell orders because

 18 then that again can lead to concerns about whether

 19 or not there are "problems" in the market. But I

 20 think one of the things that we've spent a lot of

 21 time on and which I think the committee does have

 22 a general view on is that liquidity is now
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 1 something that is going to come about through the

 2 coordination of markets and people in them and

 3 coordination has to rely on information.

 4 MR. KIRILENKO: I'd like to chime along

 5 similar lines in that very section. To me that

 6 section was also information but also

 7 transparency, increasing transparency to the

 8 markets, and from that perspective did the Joint

 9 Advisory Committee have some thoughts on how

 10 market regulators could become more transparent

 11 from a data standpoint? Is there some data that

 12 you think that as we bring it in and we work with

 13 it we should be releasing more to the markets on

 14 that? Since markets are so fast now then maybe we

 15 should be releasing data faster. What kind of

 16 data would markets need to have to be more

 17 efficient?

 18 MR. KETCHUM: I think those are very

 19 provocative and intriguing questions. I can't say

 20 that they were specifically what the committee

 21 focused on so that we can certainly focus on it

 22 going forward. And your initial statement that we
 99

 1 were very interested in enhancing the transparency

 2 to ensure greater understanding and less

 3 uncertainly is absolutely correct so that we would

 4 be pleased to talk more with staffs about that

 5 going forward.

 6 MR. BRENNAN: Rick and I thank our

 7 subcommittee members. Again this is a hard

 8 process to get eight people to work together

 9 without working together. Secondly, we want to

 10 thank the staffs. The work by your staffs as has

 11 been mentioned on their reports has been

 12 outstanding and their support in this process has

 13 been outstanding and we're very grateful for that

 14 so that before we get to voting or anything else,

 15 I wanted to make sure that our gratitude was on

 16 the record.

 17 CHAIRMAN SCHAPIRO: Thank you very much.

 18 Let me also before we vote say how grateful again

 19 we are to your efforts and that we could get such

 20 talented people with incredibly busy lives to give

 21 up the time to help us and give us your best

 22 thinking is really a gift and we very much
 100

 1 appreciate it.

 2 I'm going to go ahead and call for the

 3 vote. Let me note that because Chairman Gensler

 4 and I are the administrative co-chairs of the

 5 committee, we did not participate in the drafting

 6 or the meetings or the discussions so that we will

 7 not vote on the report, it would seem a little

 8 awkward in any event since you're voting to

 9 provide it to us. With that caveat, all those

 10 committee members in favor of submitting the

 11 report to the Commission please say aye.

 12 (Chorus of ayes.)

 13 CHAIRMAN SCHAPIRO: With no opposed I

 14 think. The ayes have it unanimously and the

 15 report is now accepted. If there aren't any other

 16 questions, I guess I will turn it back to Gary to

 17 conclude.

 18 CHAIRMAN GENSLER: I'd like to close by

 19 thanking Commissioners from the CFTC and SEC for

 20 participating and their thoughtfulness. It's now

 21 to be taken up I guess by 10 Commissioners and you

 22 had two subcommittees and we have two Commissions.
 101

 1 I really again want to thank all eight of the

 2 committee members. Your schedules are enormous,

 3 your expertise, I can tell by the fidelity and the

 4 detail of the conversation even today that we'll

 5 continue to benefit. You're not going anywhere.

 6 This is a committee that I think has been

 7 enormously beneficial for the two Commissions to

 8 continue to get your advice and counsel.

 9 As a reminder again to the public, the

 10 document itself has been posted to our individual

 11 websites at the CFTC and the SEC. We do invite

 12 interested persons to review these materials and

 13 post their own comments and observations on the

 14 committee's work and particularly as we're in a

 15 very active period of looking at Dodd-Frank to

 16 post comments to the extent that they relate to

 17 Dodd-Frank. Many of the comments related broader

 18 to market structure, but where they do relate that

 19 would be very helpful. I want to thank you and I

 20 want to thank staff as well for all that you've

 21 done. I think if there is no other committee

 22 business, hearing none I'll entertain a motion to
 102

 1 adjourn. There were no minutes that I had to

 2 consider? Then I will entertain a motion to

 3 adjourn the meeting.

 4 SPEAKER: So moved.

 5 SPEAKER: Second.

 6 CHAIRMAN GENSLER: All in favor?

 7 (Chorus of ayes.)

 8 CHAIRMAN GENSLER: Not hearing any

 9 opposition, Joe, you're not opposing. No. The

 10 meeting is adjourned. Thank you.

 11 (Whereupon, at 11:39 a.m. the

 12 PROCEEDINGS were adjourned.)

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 1 CERTIFICATE OF NOTARY PUBLIC

 2 DISTRICT OF COLUMBIA

 3 I, Irene Gray, notary public in and for

 4 the District of Columbia, do hereby certify that

 5 the forgoing PROCEEDING was duly recorded and

 6 thereafter reduced to print under my direction;

 7 that the witnesses were sworn to tell the truth

 8 under penalty of perjury; that said transcript is a

 9 true record of the testimony given by witnesses;

 10 that I am neither counsel for, related to, nor

 11 employed by any of the parties to the action in

 12 which this proceeding was called; and, furthermore,

 13 that I am not a relative or employee of any

 14 attorney or counsel employed by the parties hereto,

 15 nor financially or otherwise interested in the

 16 outcome of this action.

 17

 18

 19 -----------------------------------

 20 Notary Public, in and for the District of Columbia

 21 My Commission Expires: April 14, 2011

 22