In just 40 trading days, it will be May 6, the first anniversary of the "flash crash." What has changed in the last year to prevent a repeat? And what changes lay ahead?
Mary Schapiro, chairman of the Securities and Exchange Commission, discussed that among other topics in testimony today before a subcommittee of the U.S. Senate Committee on Banking, Housing, and Urban Affairs. From her written testimony (emphasis mine on the related but often-overlooked migration of a critical mass of volume to dark or internalized venues):
"No discussion of the SEC's actions over the past year would be complete without a discussion of May 6, 2010 — the day our markets dropped more than 500 points in a matter of minutes, only to bounce back minutes later. That event reinforced the importance of our ongoing review of market structure, which we had launched months earlier with a concept release inviting comment on regulation of the changing financial markets.
"The U.S. equity market structure has changed dramatically in recent years. A decade ago, most of the volume in stocks was executed manually, whether on the floor of an exchange or over the telephone between traders. Now nearly all orders are executed by fully automated systems at great speed. The fastest exchanges and trading venues are now able to accept, execute, and send a response to orders in less than one thousandth of a second.
"Speed is not the only thing that has changed. As little as five years ago, the great majority of U.S. equities capitalization was traded on a listing market — the New York Stock Exchange (NYSE) — that executed nearly 80 percent or more of volume in those stocks. Today, the NYSE executes approximately 22 percent of the volume in its listed stocks. The remaining volume is split among 15 public exchanges, more than 30 dark pools, 3 electronic communication networks (ECNs), and more than 200 internalizing broker-dealers. Currently, more than 30 percent of the volume in U.S.-listed equities is executed in venues that do not display their liquidity or make it generally available to the public, reflecting an increase over the last year.
"The evolution of trading technologies has dramatically increased the speed, capacity, and sophistication of the trading functions that are available to market participants. The new electronic market structure has opened the door for entirely new types of professional market participants. Today, proprietary trading firms play a dominant role by providing liquidity through the use of highly sophisticated trading systems capable of submitting many thousands of orders in a single second. These high-frequency trading firms can generate more than a million trades in a single day and now account for more than 50 percent of equity market volume.
"Public feedback from a wide variety of market participants has been that today's market structure clearly offers many advantages, including reduced trading costs, when compared to the markets of ten, and even just five years ago. Nevertheless, as highlighted by the events of May 6, the current structure has many potential issues that should be studied and addressed where appropriate. High-speed, algorithm-driven electronic trading has increased the risk of sudden liquidity imbalances that can lead to disorderly market conditions and unexpected volatility. The continuing growth of trading in dark pools and other types of dark venues can challenge the quality of the market's price-discovery function. And the complexity of the market structure sometimes makes it difficult for even sophisticated investors to pursue their own best interests.
"Over the past year, the SEC has engaged in a dedicated effort to study and learn from the experiences of May 6, with the aim of taking action to preserve the benefits of the current structure while minimizing its downsides. The agency worked with FINRA and the exchanges to develop rules that trigger circuit breakers for certain individual stocks, clarify up front how and when erroneous trades would be broken, and effectively prohibit "stub quotes" in the U.S. equity markets. We adopted a rule that prohibits broker-dealers from providing their clients with unfiltered access to exchanges, and proposed the creation of a large trader reporting system that would enhance our ability to identify large market participants, collect information on their trades, and analyze their trading activity.
"We also proposed a new rule that would require the creation of a consolidated audit trail that would enable regulators to track information about trading orders received and executed across the securities markets. Today, there is no standardized, automated system to collect data across the various trading venues, products, and market participants. Each market has its own individual and often incomplete data collection system, and as a result, regulators tracking suspicious activity or reconstructing an unusual event must obtain and merge an immense volume of disparate data from a number of different markets. And even then, the data does not always reveal who traded which security, and when. To obtain individual trader information, the SEC must make a series of manual requests that can take days or even weeks to fulfill. In brief, the Commission's tools for collecting data and surveilling our markets are wholly inadequate to the task of overseeing the largest equity markets in the world.
"The proposed consolidated audit trail rule would require the exchanges and FINRA to jointly develop a national market system (NMS) plan to create, implement, and maintain a consolidated audit trail in the form of a newly-created central repository. The information would capture each step in the life of the order, from receipt or origination of an order, through the modification, cancellation, routing and execution of an order. Notably, this would include information identifying the "ultimate customer" who generated the order. And, it would require members to "tag" each order with a unique order identifier that would stay with that order throughout its life.
"If implemented effectively, the consolidated audit trail would, for the first time, allow self-regulatory organizations (SROs) and the Commission to track trade data across multiple markets, products and participants simultaneously. It would allow us to rapidly reconstruct trading activity and to more quickly analyze both suspicious trading behavior and unusual market events. It is important to recognize, however, that the consolidated audit trail is a major change in the technology infrastructure for our equity markets, and thus will require some time to fully implement. In addition, in order to fully use this new infrastructure, the Commission's own technology and human resources will need to be expanded well beyond their current levels."