In his testimony before the Subcommittee on Securities, Insurance, and Investments in the United States Senate on March 3, 2016, FINRA Chairman and CEO Richard Ketchum spoke about three key aspects of the markets that securities market participants and regulators alike should continually strive to strengthen: market fairness, market transparency, and market liquidity. Chairman Ketchum acknowledged that SEC Chair Mary Jo White has instituted a plan for potential future changes in the equity and fixed income markets, which demands an important supporting role from FINRA and other self-regulatory organizations (SROs). While some changes have been made, many are still being considered and analyzed, all of which focus on proposals that will effectuate increased market fairness, transparency, and liquidity.
In discussing market structure, Ketchum highlighted the shift in equity markets from human-intermediated markets to electronic intermediation, where automated trading has become the norm. This pictorially is an evolution from traditional brokers manning the floor to a sea of computers supporting the latest automated trading platforms, including high frequency trading (HFT). These changes have been furthered by technological advancements coupled with regulatory action, including Regulation ATS , decimalization, and Regulation NMS, all of which Ketchum says have a common goal for promoting competition, lowering costs, and enhancing best execution. While these conditions have impacted market structure in ways that are not always easily explained, Ketchum said that does not prevent regulatory improvement but rather emphasizes the need for careful data analysis. Such analysis has expanded through implementations such as the SEC’s Market Information Data Analytics System (MIDAS) project, which includes data from individual proprietary feeds to offer a more complete empirical data set to better understand the market, and FINRA’s Order Audit Trail System (OATS), which is used to monitor the life cycle of orders and capture the trading practices of member firms. These projects are helpful, but Ketchum understands that with potential inefficiencies in the market there is still “work to be done” on the regulators end.
Identifying the “increasingly fragmented market,” Ketchum expressed that it is FINRA’s job to oversee what is happening in the market and make sure that they are operating fairly. This requires close monitoring of bad actors who have the ability to conceal their trading activity across markets, asset classes and broker-dealers. Ketchum said that as a product of its various agreements with U.S. equity exchanges and U.S. options exchanges, FINRA has been able to compile trading data from all markets to conduct comprehensive, cross market surveillance to help reveal the bad actors. In an effort to expand its market surveillance, FINRA is beginning to create programs that will cover equities and options markets together to detect possible cross-product manipulative conduct. Ketchum noted that the surveillance is not entirely on their shoulders as a number of existing SEC and FINRA rules require firms with market access to have a system of effective risk management controls and supervisory procedures in place. Nevertheless, the role of SEC and FINRA role is essential to ensuring the integrity in the markets and maintaining the confidence of investors. This has been enhanced by partnering with 19 SROs and the 18 national securities exchanges through Exchange Act Rule 613 to maintain a Consolidated Audit Trail (CAT) to serve as the world’ largest repository of securities data.
Transparency, among all of the quality concerns of the market, appears most critical to investors. Ketchum explained that the FINRA Board of Governors formed a Working Group to assess FINRA’s rules and regulatory programs related to HFT, which prompted initiatives targeted at increasing trading information FINRA receives and transfer such information to market participants and investors. These efforts have centered on alternative trading systems (ATSs) to offer more detailed order information, including “more granular audit trail information and tighter restrictions around allowable clock drift to better ensure proper sequencing.” Expanding its initiative from 2014, FINRA will be publishing monthly aggregate ATS block trading statistics and by publishing the remaining equity volume executive over-the-county by FINRA members firms. FINRA, as outlined in its recent comment letter proposal for the SEC’s disclosure regime involving NMS Stock ATS, fully supports the SEC’s initiative to improve disclosures covering the operation of business dealing of NMS Stock ATSs and requisite oversight of these ATSs filings.
Market Liquidity and Volatility
The pinnacle of market news, market liquidity and volatility, peaked in 2010 with the May 2010 flash crash, which collectively, the SEC, FINRA and U.S. stock exchanges responded to with the various programs creating a “multi-faceted safety net” for the markets and to, of course, improve investor confidence in the markets. Ketchum highlighted some of the changes, including adjusting the market-wide training pause, which gives market participants an opportunity to evaluate their positions, valuation models, and operational capabilities when extreme periods of volatility occur. In 2012, FINRA unrolled a Limit Up/Limit Down (LULD) Plan to prevent trades in NMS stock from occurring at prices outside of specific price bands. This plan was put to the test on August 24, 2015, when the Dow dropped more than 1,000 points, which caused over 1,200 trading pauses, creating a controlled environment to limit dramatic market fluctuations. On August 24th, we also saw the pricing effect on exchange-traded funds (ETFs), which has triggered regulators to review a number of issues and the effectiveness of the initiatives put in place after the 2010 Flash Crash.
Work in Progress
Ketchum explained that as a member of the SEC’s Equity Markets Structure Advisory Committee (EMSAC), he, along with other EMSAC members and the SEC have dedicated significant time and effort to coordinate plans to improve market conditions. FINRA is supporting these efforts by in part, considering establishing additional guidance to firms to educate investors regarding the LULD plan and the risks of market and stop orders. Additionally, FINRA is involved in a number of projects concerning small companies. These include a pilot program designed to assess the impact of increment conventions (known as tick sizes) on the liquidity and trading of the common stock of small-cap companies and FINRA’s proposed rules and forms for SEC-registered funding portals stemming from the JOBS Act crowdfunding provisions set to become effective Mary 16, 2016.
In addition to Ketchum’s testimony regarding capital markets, he also received questioning from Sen. Elizabeth Warren as to how FINRA is responding to investor protection concerns. Ketchum explained that something should be done about firms lacking funds to pay customer arbitration awards and that FINRA will want to work with the SEC on resolving it. This problem is heightened by firms that become insolvent or that leave FINRA, upon which FINRA loses its jurisdiction over them. FINRA is looking at whether there should be regulatory mechanisms to ensure that firms have sufficient capital before they retire their membership with FINRA, but this may not happen for some time. As for taking a clear stance in the near future, Ketchum said “With respect to any firm that continues to do business in the securities industry, unless they leave and become a registered investment advisor, we will bar them if they don’t pay their awards. Plain and simple as that. No one can stay in as a FINRA member and not pay their arbitration awards.” Sen. Warren also raised concerns about registered representatives who commit violations but are permitted to reenter the industry. This issue was highlighted in a working paper by the University of Chicago and University of Minnesota about financial advisors’ misconduct and among other topics, focused on recidivism and the most affected investor population. In response to Sen. Warren’s questions as to representatives’ misconduct, Ketchum said, “That’s exactly the risk we look at with respect to our exams and enforcement investigations. And that’s why many of those people get barred every year.”
Ketchum identified the major issues always percolating through the industry and investors alike – market fairness, transparency, and liquidity and volatility. As technology changes, products change, and the general trading environment changes, FINRA, along with the SEC, are under pressures to be a step ahead of the markets. Part of this task requires a balance of history lessons, using data to track past occurrences while keeping up with live updates and monitoring daily market activity, including current activity stemming from new market participants and those outside the market, such as equity crowdfunding sites. Adding to the capital markets discussion, Ketchum delved into an area directly affecting investors—arbitration awards and firms failure to pay, as well as, representatives’ manipulative conduct, which FINRA will have to work with the SEC to resolve. Combating the issues identified by Ketchum is a work in progress that, absent a magic 8 ball, demands strengthening measures to monitor the markets, member firms, and industry participants.