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Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues

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S. HRG. 111–434 DARK POOLS, FLASH ORDERS, HIGH-FREQUENCY TRADING, AND OTHER MARKET STRUCTURE ISSUES HEARING BEFORE THE SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT OF THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED ELEVENTH CONGRESS FIRST SESSION ON EXAMINING THE DARK POOLS, FLASH ORDERS, HIGH-FREQUENCY TRADING, AND OTHER MARKET STRUCTURE ISSUES OCTOBER 28, 2009 Printed for the use of the Committee on Banking, Housing, and Urban Affairs ( Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html U.S. GOVERNMENT PRINTING OFFICE 56–562 PDF WASHINGTON : 2010 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS CHRISTOPHER J. DODD, Connecticut, Chairman TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama JACK REED, Rhode Island ROBERT F. BENNETT, Utah CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky EVAN BAYH, Indiana MIKE CRAPO, Idaho ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee DANIEL K. AKAKA, Hawaii JIM DEMINT, South Carolina SHERROD BROWN, Ohio DAVID VITTER, Louisiana JON TESTER, Montana MIKE JOHANNS, Nebraska HERB KOHL, Wisconsin KAY BAILEY HUTCHISON, Texas MARK R. WARNER, Virginia JUDD GREGG, New Hampshire JEFF MERKLEY, Oregon MICHAEL F. BENNET, Colorado EDWARD SILVERMAN, Staff Director WILLIAM D. DUHNKE, Republican Staff Director DAWN RATLIFF, Chief Clerk DEVIN HARTLEY, Hearing Clerk SHELVIN SIMMONS, IT Director JIM CROWELL, Editor SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT JACK REED, Rhode Island, Chairman JIM BUNNING, Kentucky, Ranking Republican Member TIM JOHNSON, South Dakota JUDD GREGG, New Hampshire CHARLES E. SCHUMER, New York ROBERT F. BENNETT, Utah EVAN BAYH, Indiana MIKE CRAPO, Idaho ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee DANIEL K. AKAKA, Hawaii DAVID VITTER, Louisiana SHERROD BROWN, Ohio MIKE JOHANNS, Nebraska MARK R. WARNER, Virginia MICHAEL F. BENNET, Colorado CHRISTOPHER J. DODD, Connecticut KARA M. STEIN, Subcommittee Staff Director WILLIAM HENDERSON, Republican Subcommittee Staff Director RANDY FASNACHT, GAO Detailee (II) CONTENTS WEDNESDAY, OCTOBER 28, 2009 Page Opening statement of Chairman Reed ................................................................... 1 Prepared statement .......................................................................................... 44 Opening statements, comments, or prepared statements of: Senator Bunning ............................................................................................... 2 Prepared statement ................................................................................... 44 WITNESSES Edward E. Kaufman, Senator from the State of Delaware .................................. 3 Prepared statement .......................................................................................... 45 James Brigagliano, Coacting Director, Division of Trading and Markets, Secu- rities and Exchange Commission ........................................................................ 7 Prepared statement .......................................................................................... 57 Responses to written questions of: Senator Menendez ..................................................................................... 90 Senator Vitter ............................................................................................ 91 Frank Hatheway, Senior Vice President and Chief Economist, NASDAQ OMX ...................................................................................................................... 8 Prepared statement .......................................................................................... 61 William O’Brien, Chief Executive Officer, Direct Edge ........................................ 10 Prepared statement .......................................................................................... 63 Christopher Nagy, Managing Director of Order Routing Sales and Strategy, TD Ameritrade ..................................................................................................... 13 Prepared statement .......................................................................................... 65 Daniel Mathisson, Managing Director and Head of Advanced Execution Serv- ices, Credit Suisse ................................................................................................ 14 Prepared statement .......................................................................................... 67 Robert C. Gasser, President and Chief Executive Officer, Investment Tech- nology Group ........................................................................................................ 16 Prepared statement .......................................................................................... 71 Peter Driscoll, Chairman, Security Traders Association ...................................... 18 Prepared statement .......................................................................................... 84 Responses to written questions of: Senator Bunning ....................................................................................... 93 Adam C. Sussman, Director of Research, TABB Group ....................................... 20 Prepared statement .......................................................................................... 88 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Statement submitted by Larry Leibowitz, Group Executive Vice President and Head of U.S. Execution and Global Technology for NYSE Euronext ....... 94 Statement submitted by Thomas M. Joyce, Chairman and Chief Executive Officer, Knight Capital Group, Inc. .................................................................... 100 Statement submitted by the Investment Company Institute .............................. 107 (III) DARK POOLS, FLASH ORDERS, HIGH-FRE- QUENCY TRADING, AND OTHER MARKET STRUCTURE ISSUES WEDNESDAY, OCTOBER 28, 2009 U.S. SENATE, SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Subcommittee met at 9:32 a.m., in room SD–538, Dirksen Senate Office Building, Senator Jack Reed (Chairman of the Sub- committee) presiding. OPENING STATEMENT OF CHAIRMAN JACK REED Chairman REED. Let me call the hearing to order, and I want to begin by welcoming my friend and colleague, Senator Ted Kauf- man. Ted has spent a considerable amount of time examining some of these cutting-edge issues facing increasingly high-tech capital markets. And I also want to welcome the witnesses who will join us for the second panel. As many families struggle to regain their footing, stay in their homes, and keep their jobs in the wake of a severe recession caused by reckless profit seeking on Wall Street, it is appropriate and timely to meet today to ask questions about the role of technology in our financial markets. Today’s hearing is a check-up on our eq- uity markets amid concerns that technological developments in re- cent years may be disadvantaging certain investors. Electronic trading has evolved dramatically over the last decade, and it is important that regulators keep up. For example, trading technology today is measured not in seconds or even milliseconds, but it in microseconds, or one-millionth of a second. So even a sneak peek of a fraction of a second using what is called a ‘‘flash order’’ may give some market participants a significant advantage. Our hearing will take a closer look at such flash orders, along with other market structure issues such as dark pools, which are private trading systems that do not display quotes publicly; and high-frequency trading, a lightning-fast computer-based trading technique. According to the SEC, the overall proportion of displayed market segments, those that display quotations to the public, has remained steady over time at approximately 75 percent of the market. How- ever, undisplayed liquidity has shifted from taking place on the floor of the exchanges or between investment banks to what are (1) 2 currently known as ‘‘dark pools,’’ with the number of such pools in- creasing from approximately 10 in 2002 to approximately 29 in 2009. Dark pools today account for about 7.2 percent of the total share of stock volume. Dark pools and other undisplayed forms of liquidity have been considered useful to investors moving large numbers of shares since it allows them to trade large blocks of shares of stock without giving others information to buy or sell ahead of time. However, some critics of dark pools argue that this has created a two-tiered market in which only some investors in dark pools, but not the general public, have information about the best available prices. The SEC has recently proposed changes in this area to bring greater transparency to these pools. Flash orders and high-frequency trading have also raised con- cerns. Flash orders, which enable investors who are not publicly displaying quotes to see orders before other investors, have raised questions about fairness in the markets, and the SEC has recently proposed to ban them. High-frequency trading, a much more com- mon technique used extensively throughout the markets, is the buying and selling of stock at extremely fast speeds with the help of powerful computers. This activity has raised concerns that some market participants are able to game
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