Source: Securities and Exchange Commission

Thank you for having me here today as part of the 12th Annual Conference on Financial Market Regulation. Before I begin, I must remind you that my views are my own as a Commissioner and not necessarily those of the SEC or my fellow Commissioners. I appreciate the collaboration of the SEC’s Division of Economic and Risk Analysis, Lehigh University’s Center for Financial Services, and the University of Virginia’s Darden School of Business in hosting this conference. The Commission benefits from economic research on financial regulation.

Given that the SEC is a market regulator, I am disappointed when deprecation of economic fundamentals slips into the Commission’s work. An incident recounted by Ulysses S. Grant in his memoirs reminded me of a quibble I had with the justification for a recent Commission rulemaking. When Grant was about eight years-old, his father dispatched him to buy a horse: impressive, even if his negotiating skills proved not to be. Grant’s father thought the horse worth only twenty dollars, but told the young Grant—who desperately wanted the animal—that he should start by offering twenty dollars and could work his way up to twenty-five. The future Union general and U.S. president implemented his father’s instructions as follows: “Papa says I may offer you twenty dollars for the colt, but if you won’t take that, I am to offer twenty-two and a half, and if you won’t take that, to give you twenty-five.”[1] He paid twenty-five.

The incident in which he informed his counterparty to his own detriment was long a source of embarrassment for Grant, but how much more embarrassing it is for a market regulator to suggest that fully informed traders are a prerequisite for fair markets. The Commission took that position in its recent rulemaking to shorten beneficial ownership reporting timelines; it justified faster mandatory reporting of position build-ups on the theory that buyers who voluntarily sell at a price that has not incorporated all available information suffer harm by not having information that other investors have.[2] As I said at the time, the SEC was “invent[ing] investor harm . . . We want to encourage investors to ferret out information and find undervalued companies. Indeed, information asymmetries in this sense—where investors have equal access to disclosure from the issuer and insiders, but come to different conclusions about the long term prospects of a company based on their respective due diligence—are a feature, not a bug, of our capital markets.”[3] The eight-year-old Grant’s horse trade was his tutor on market principles.[4] So too the ninety-year-old SEC needs tutorials—provided by economists like you—to refresh our acquaintance with market principles.

Economists are essential partners in the difficult task of writing rules to protect investors and market integrity. You can help us analyze whether market behaviors are the natural outcome of supply and demand, innovation, and competition, or whether they are a consequence of the rules that govern that market. In the latter case, you can assist us in assessing whether regulation has changed the markets for better or worse. Economists understand that markets effectively solve problems that look intractable to many a regulatory lawyer, and that regulation often exacerbates problems or creates new ones. Economists, of course, are not perfect. They, right along with lawyers, can get entranced with the power and promise of regulatory lever-pulling. A commitment to basic economic principles, however, helps combat tendencies toward regulatory micromanagement. Accordingly, today, I want to enlist your help in thinking about exchanges.

Market structure issues are notoriously complicated to diagnose and to resolve, but economic research can help us do both. We have spent a lot of time in recent years tinkering with equity market structure. I have supported some of those changes, including improvements to market data infrastructure, enhanced execution quality reporting requirements, and tick size changes. I have objected to others out of a concern that they would lead to inferior execution and decreased investor choice. As I considered each equity markets initiative, even those I supported, I could not help but wonder: What would the market landscape look like if the SEC were not micromanaging it? Would we have so many exchanges? Would they be more heterogeneous? Would a single exchange offer different trading models? Would they be self-regulating, or would they have outsourced that responsibility? How would they charge for market data? Would off-exchange trading platforms, like ATSs, have developed differently or not at all? Would the internalization of trades be as prevalent? And, most important, would the market be better or worse for issuers, investors, and traders without all the micromanagement?

My starting point is that people do not need a government regulator to make markets. If one person has something that someone else wants, a market transaction can make both better off. Humans grasp this principle without external prodding; buyers and sellers organically find each other all the time and in all sorts of places. Third parties, from your local farmer’s market to a giant online marketplace, routinely step in to intermediate these sales. Again, their involvement occurs naturally: people, of their own volition, identify and fill a need to establish a market. Markets for bringing together suppliers and consumers of capital also emerge organically. Brokers to help people buy and sell and exchanges where such transactions could occur arose without government orchestration.[5] Innkeepers in Belgium and proprietors of coffee houses in London cultivated exchanges.[6] Eventually, some of these venues transformed into self-regulating exchanges.[7] The storied Buttonwood Agreement of 1792 established the first set of rules for commissions and how stocks could be traded on what would become the New York Stock Exchange, and rival exchanges grew and proliferated. Throughout the 1800s, exchanges—which their members owned—developed an increasingly sophisticated set of rules that governed trading, adjudicated disputes among members, and disciplined members for violations. More recently, we have seen the introduction of autonomous trading protocols to facilitate crypto transactions. Users of these protocols submit to regulation also, albeit by software code. The ability of markets to emerge, expand, and self-regulate without government involvement should keep us all humble.

Because markets arise and thrive on their own, government should involve itself only where it can improve their functioning. When it first wrote the securities laws, established the SEC, and gave it authority over exchanges, Congress decided that securities markets would benefit from government intervention. Congress recognized, however, the role exchanges played in regulating the markets and feared that too much direct regulation of the securities industry would prove ineffective.[8] Therefore, while the Exchange Act required exchanges to register with the Commission, their self-regulatory nature was retained. Congress charged exchanges with enforcing Exchange Act provisions against their members and disciplining any member that acted “inconsistent with just and equitable principles of trade.”[9] The Exchange Act preserved for them, however, what a later Congress described as “seemingly open-ended authority”[10]to promulgate rules so long as they were not inconsistent with the Exchange Act or state law.[11]

Four decades later, in the Securities Acts Amendments of 1975, Congress amended the Exchange Act to tighten Commission oversight of exchanges. New section 19(b) of the Exchange Act bolstered requirements for self-regulatory organizations (“SROs”), including the exchanges, to file and seek Commission pre-approval for all rule changes.[12] The “open-ended authority” that previously applied to exchange rulemaking was gone—replaced by an amended section 6(b)(5), which required that any rule promulgated by the exchange be designed to achieve a set of specific purposes and standards and prohibited exchanges from regulating “matters not related to the purposes” of the Exchange Act.[13]

The 1975 amendments also gave the Commission a new cross-exchange mandate to “facilitate the establishment of a national market system for securities.”[14] Given that a national market already existed, the Commission needed, in the words of the Commission’s then Chairman, to commit itself “to a search for, and the development of, the national market system that the Congress has ordered.”[15] Two years later, the SEC’s new Chairman lamented the “current rate of progress” and warned industry that if it did not take the lead in creating such a system that satisfied his vision for a national market system,[16] the SEC would.[17] The Commission took steps over the years to link markets in response to the 1975 directive,[18] but a fresh push came three decades later in Regulation NMS. Central to the 2005 effort was the controversial Order Protection Rule (“OPR”),[19] which was intended to ensure competition among orders across markets and reward market participants for publicly displaying quotes.[20]

At first glance, the exchange landscape looks vibrant. Right now, there are 16 operating exchanges that trade equities, and more exchanges are waiting in the wings. In the past half-year, the Commission has approved three new equity exchanges that have yet to commence operations.[21] The Commission currently is considering applications for two new equity exchanges. If all these exchanges are approved and begin operating, the market will have 21 equity exchanges, compared to 11 in 2014 and 8 (plus Nasdaq, which was not yet an exchange) in 2005. If twenty-one seems high, consider that in 1934, when exchanges were first required to register with the newly formed Commission, 36 exchanges operated throughout the country.[22] At that time, regional exchanges had sprung up to raise capital for local industries shunned by New York money. For example, in my hometown of Cleveland an exchange founded in 1900 helped raise capital for local firms in the newly emerging rubber industry and the always-present brewery industry.[23] Since then, however, the number of exchanges had been declining steadily until recently. In the 72 years between 1934, when exchanges were first required to register, and 2006, when Nasdaq registered as an exchange, few new exchanges formed, and fewer survived.[24] My cherished Cleveland exchange lasted only until 1949, when it merged with stock exchanges in Chicago, Minneapolis-St. Paul, and St. Louis to become the Midwest Exchange.[25]

While different types of exchange trading models exist and issuers have several listing options, the exchange landscape feels a bit like a modern subdivision with acres of undifferentiated houses. Some of these new exchanges have been innovative: they have offered new ways to trade, such as speed bumps and extended hours. But many exchanges offer few differences in terms of how stocks trade beyond their pricing and rebate models. Some entrants file applications that display no intent to innovate. Exchanges generally do not serve particular regions or industries as they once did.

This largely homogenous, proliferating exchange landscape may be a product of government regulation. One cause may be the Order Protection Rule, which generally prohibits transactions on an exchange from executing at a price that is inferior to the best price on any other exchange. In practice, to comply with this rule and with best execution obligations, market participants connect to all exchanges, even those with limited liquidity, on the chance that the best price could be located there. Consequently, an exchange can earn significant revenue through connectivity and market data fees regardless of how much trading volume it attracts or how many issuers choose to list there. Among the sixteen exchanges, half of them capture less than 1% of total market volume each.[26] Many exchanges sit within families operated by a single exchange operator. Each additional exchange brings new connectivity fees, new market data fees, and additional clout on the committee that sets those fees.

Even with all these exchanges, approximately half of volume takes place off-exchange. Here we see more variety. Alternative trading systems, or ATSs, have proliferated since the turn of this century and are trading venues with functionalities similar to those offered by exchanges. ATSs differ from exchanges largely as a result of regulatory policy, rather than market function.[27] Thirty-three ATSs currently trade equities, [28] and several of them have greater trading volume than some exchanges.[29] These ATSs offer different trading models to cater to different investors. In addition to off-exchange trading on ATSs, wholesalers, which internalize trades, execute a sizable proportion of total retail trades. ATSs and internalizers can do things, such as segmenting retail and institutional order flow, that exchanges cannot do. Statutory and regulatory prohibitions prevent exchanges from treating one set of market participants differently than another or inhibiting access to their quotations, while most ATSs are permitted to choose who can use their venue.[30] Moreover, ATSs and internalizers, which are not subject to Section 19(b) rule filing requirements, can be more flexible than exchanges so they can adopt new technologies more quickly.

The primary regulatory difference between exchanges and ATSs is that the former are SROs and the latter are not. Exchanges enjoy certain benefits as SROs, chief among which is that they are entitled to absolute immunity with respect to the regulatory functions delegated to them under the Exchange Act. Moreover, exchanges are able to substantially cap their liabilities through rule-based liability limits contained in their rulebooks. But they also face constraints that ATSs and internalizers do not. They have to regulate and surveil their own markets, monitor and supervise the conduct of their members, and enforce their own rules. If an exchange fails to enforce its own rules, the Commission may bring an enforcement action against it.[31] An ATS, even one with a higher market share than an exchange, has fewer and lighter obligations, although an ATS laboring under the burden of Regulation SCI might not feel lightly regulated.

Section 19(b) rule filing requirements can be particularly constraining on exchanges. Exchanges have to file with the SEC any new rule or amendment to an existing rule, which can lead to a lengthy public notice and comment process. This process makes initiating and changing operations, products and services, technologies, and fees cumbersome and slow, and can make it hard for an exchange to maintain an innovation as a trade secret.[32] Incidentally, this process also is burdensome for Commission staff. Moreover, after the exchange has gone through the costly and time-consuming process of seeking and gaining SEC approval for its innovation, other exchanges can copy it,[33] as has happened several times in the recent past. Exchange operators that have sought to supplement their exchange business with other profit-making activities also have run into the Commission’s broad reading of “facility” of an exchange.[34] If something is deemed to be a facility of the exchange, it is subject to the same regulation and rule filing requirement as the exchange itself, with all its added costs and burdens. Congress, in section 6(b)(5) of the Exchange Act, also prohibited exchanges from “regulat[ing] by virtue of any authority conferred by this chapter matters not related to the purposes of this chapter or the administration of the exchange.”[35] This prohibition is appropriate—allowing exchanges to capitalize on their authority as government-sanctioned SROs to force conduct unrelated to that authority can be very problematic.[36] But this statutory limitation does make it difficult for exchanges to differentiate themselves by catering to a specific segment of the market.

What, if anything, should be done about this state of affairs? We could consider more targeted changes to the rules governing the equity markets to enhance true competition among trading and listing venues. We could eliminate the OPR, limit its application to exchanges that meet certain thresholds, or modify it in other ways. We could narrow our interpretation of facility or provide exemptions with commercially reasonable conditions. We could offer more flexibility for trading venues to concentrate liquidity for less liquid stocks or more choice by issuers around how their stocks trade. We could consider whether the current liability limitations in exchange rulebooks are appropriate. And we should not be afraid to allow exchanges to try targeted experimentation along the lines of our 2019 effort to facilitate innovative proposals for changes in equity market structure to improve trading in thinly traded securities.[37]

We could also consider whether changes to exchange SRO status would be appropriate. Throwing out the exchange SRO model in its entirety would be premature, although questions about the model are not novel. The Commission has previously solicited comments about self-regulation.[38] And nearly thirteen years ago, my predecessor Commissioner Gallagher raised many questions about the SRO model, including whether exchanges should still be SROs.[39] Given the increased proliferation of exchanges and the further fragmentation of the equity markets since then, his questions remain worthy of consideration. Changes to the SRO status of exchanges would require Congressional action and demand careful thought and scrutiny before going forward. Exchanges without SRO status would likely no longer enjoy absolute immunity, but would also likely be freed, at least somewhat, of the burdens of the 19(b) rule filing process or the 6(b)(5) limitations on its rules being related to the purposes of the Exchange Act. Any such change would have to be undertaken with consideration of potential effects on market quality.

Even though our markets are regulated more intensely and with greater complexity than I would prefer, they work remarkably well. Retail investors have easier and cheaper access to these markets than ever. In the face of recent high volumes and volatility, the markets have performed well. Investors and issuers from all over the world look to U.S. markets to invest, raise capital, and trade. Altering the regulatory framework could diminish the quality of our markets, so we must undertake any change with care, proper deliberation, and concern for unintended consequences.

An audience of economists who appreciate opportunity costs recognizes that time spent on equity market structure is not available for other things. And many other issues clamor for the SEC’s attention. We ought, for example, to spend some time looking at the options markets, where the market and regulatory dynamics are considerably different than the equity markets. But here too we see exchange proliferation: Eighteen exchanges and counting trade options. The Commission has spent relatively little time on options issues, and I would like the agency to hold a roundtable to discuss, among other issues, the opaque and seemingly arbitrarily applied Options Regulatory Fee, strike proliferation, and new types of options. More economic research on these issues, and the options market in general, will help inform any future actions the Commission may take. Other issues that compete for Commission attention include small business capital formation, the decline in public listings, modernization of rules governing transfer agents, regrounding disclosure requirements in materiality, facilitating use of modern technology in communications with investors, increasing fixed income market transparency, and providing regulatory clarity for crypto assets, to name a few. Conferences like this one are so valuable precisely because your research can help us think about how best to spend our limited regulatory resources. Your work can identify problems to solve and weigh different solutions to those problems. Thank you and enjoy the rest of the conference.

Section 19(b) rule filing requirements can be particularly constraining on exchanges. Exchanges have to file with the SEC any new rule or amendment to an existing rule, which can lead to a lengthy public notice and comment process. This process makes initiating and changing operations, products and services, technologies, and fees cumbersome and slow, and can make it hard for an exchange to maintain an innovation as a trade secret.[40] Incidentally, this process also is burdensome for Commission staff. Moreover, after the exchange has gone through the costly and time-consuming process of seeking and gaining SEC approval for its innovation, other exchanges can copy it,[41] as has happened several times in the recent past. Exchange operators that have sought to supplement their exchange business with other profit-making activities also have run into the Commission’s broad reading of “facility” of an exchange.[42] If something is deemed to be a facility of the exchange, it is subject to the same rule filing process as the exchange itself, with all its added costs and burdens. Congress, in section 6(b)(5) of the Exchange Act, also prohibited exchanges from “regulat[ing] by virtue of any authority conferred by this chapter matters not related to the purposes of this chapter or the administration of the exchange.”[43] This prohibition is appropriate—allowing exchanges to capitalize on their authority as government-sanctioned SROs to force conduct unrelated to that authority can be very problematic.[44] But this statutory limitation does make it difficult for exchanges to differentiate themselves by catering to a specific segment of the market.

What, if anything, should be done about this state of affairs? We could consider more targeted changes to the rules governing the equity markets to enhance true competition among trading and listing venues. We could eliminate the OPR, limit its application to exchanges that meet certain thresholds, or modify it in other ways. We could narrow our interpretation of facility or provide exemptions with commercially reasonable conditions. We could offer more flexibility for trading venues to concentrate liquidity for less liquid stocks or more choice by issuers around how their stocks trade. We could consider whether the current liability limitations in exchange rulebooks are appropriate. And we should not be afraid to allow exchanges to try targeted experimentation along the lines of our 2019 effort to facilitate innovative proposals for changes in equity market structure to improve trading in thinly traded securities.[45]

We also could consider whether changes to exchange SRO status would be appropriate. Throwing out the exchange SRO model in its entirety would be premature, although questions about the model are not novel. The Commission has previously solicited comments about self-regulation.[46] And nearly thirteen years ago, my predecessor Commissioner Gallagher raised many questions about the SRO model, including whether exchanges should still be SROs.[47] Given the increased proliferation of exchanges and the further fragmentation of the equity markets since then, his questions remain worthy of consideration. Changes to the SRO status of exchanges would require Congressional action and demand careful thought and scrutiny before going forward. Exchanges without SRO status would likely no longer enjoy absolute immunity, but would also likely be freed, at least somewhat, of the burdens of the 19(b) process rule filing or the 6(b)(5) limitations on its rules being related to the purposes of the Exchange Act. Any such change would have to be undertaken with consideration of potential effects on market quality.

Even though our markets are regulated more intensely and with greater complexity than I would prefer, they work remarkably well. Retail investors have easier and cheaper access to these markets than ever. In the face of recent high volumes and volatility, the markets have performed well. Investors and issuers from all over the world look to U.S. markets to invest, raise capital, and trade. Altering the regulatory framework could diminish the quality of our markets, so we must undertake any change with care, proper deliberation, and concern for unintended consequences.

An audience of economists who appreciate opportunity costs recognizes that time spent on equity market structure is not available for other things. And many other issues clamor for the SEC’s attention. We ought, for example, to spend some time looking at the options markets, where the market and regulatory dynamics are considerably different than the equity markets. But here too we see exchange proliferation: Eighteen exchanges and counting trade options. The Commission has spent relatively little time on options issues, and I would like the agency to hold a roundtable to discuss, among other issues, the opaque and seemingly arbitrarily applied Options Regulatory Fee, strike proliferation, and new types of options. More economic research on these issues, and the options market in general, will help inform any future actions the Commission may take. Other issues that compete for Commission attention include small business capital formation, the decline in public listings, modernization of rules governing transfer agents, regrounding disclosure requirements in materiality, facilitating use of modern technology in communications with investors, increasing fixed income market transparency, and providing regulatory clarity for crypto assets, to name a few. Conferences like this one are so valuable precisely because your research can help us think about how best to spend our limited regulatory resources. Your work can identify problems to solve and weigh different solutions to those problems. Thank you and enjoy the rest of the conference.

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