CAMBRIDGE, MA, June 18, 2014
Prof. Hal S. Scott provided testimony today on high frequency trading before the Subcommittee on Securities, Insurance, and Investment of the US Senate Committee on Banking, Housing, and Urban Affairs. Scott is the Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School and Director of the Committee on Capital Markets Regulation. In his testimony, Prof. Scott discusses the impact of high frequency trading on investor confidence and capital formation in U.S. equity markets. Prof. Scott states specifically in his opening remarks that “the emergence of HFT activity has not negatively affected our secondary markets.” Prof. Scott notes, however, that there are three areas for possible improvement of the regulatory structure:
1) Regulators should consider mandating and harmonizing exchange-level kill switches. A kill switch is a mechanism that would halt a firm’s trading activity when a pre-established exposure threshold has been breached, thus stopping erroneous orders and preventing any further uncontrolled accumulation of positions.
2) Regulators might consider addressing the volume of order message traffic, which can create market instability, by establishing order-to-trade ratios. Regulators should consider charging fees for extreme message traffic.
3) Regulators should consider abolishing immunity that exchanges have from liabilities for losses from market disruptions based on their SRO status, which might better align the exchanges’ incentives to limit potentially risky trading activity that could pose widespread operational risk.
Prof. Scott’s submitted written testimony and oral testimony can be downloaded below.
Written testimony of Hal S. Scott, Nomura Professor and Director, Program of International Financial Systems, Harvard Law School
Thank you, Chairman Warner, Ranking Member Johanns, and Members of the Subcommittee, for permitting me to testify before you today on the impact of high frequency trading on investor confidence and capital formation in U.S. equity markets. I am testifying in my own capacity and do not purport to represent the view of any organizations with which I am affiliated.
High frequency trading, or HFT, is a topic that has generated significant attention in recent years, intensifying more recently with the publication of Michael Lewis’s book, Flash Boys. It is my intention to provide a thoughtful response to a debate that has sometimes been fraught with frenzied emotion.
Let me be clear at the outset. The emergence of high frequency trading activity in and of itself has not negatively affected our secondary markets. Our secondary markets remain strong, with roughly 50 percent of global exchange trading occurring on U.S. exchanges. With roughly half of this volume generated by HFT firms, the increased liquidity provided by HFTs lead to decreased costs of stock issuance, thus improving capital formation. And, of course, improved capital formation for our businesses leads to higher growth in the real economy.
Transaction costs for retail and institutional investors have also been in continual decline over the past 10 years, as evidenced by current bid-ask spreads, and have fallen by 50 percent since 2006 and brokerage commissions that are at historic lows. Retail investors can now trade for less than $10 a trade.
Since many retail investors access the equity markets indirectly through institutional funds or advisors, like mutual funds, institutional costs are highly relevant to retail investors, as well. Leading financial economists find that the average transaction costs for institutional orders are also at an all-time low.
Investor confidence in our markets also remains strong. Since the 2010 Flash Crash, there has been a net inflow of more than $50 billion in holdings of U.S.-listed companies and a total net inflow of nearly $500 billion in all exchange-traded products. Clearly, investors are not fleeing from our equity markets due to perceived threats of high frequency trading.
Moreover, experts have found that high frequency trading has not caused an increase in stock market volatility, although I think we will go around a little bit on that. And, the SEC has also largely addressed future Flash Crash concerns by implementing single stock circuit breakers and revising marketwide circuit breakers that will temporarily halt trading if price movements become too volatile.
Critics of HFT have questioned the fairness of allowing certain traders to benefit from their physical proximity to an exchange, known as colocation, and have access to faster data feeds. However, the SEC requires exchanges to offer such access to all market participants at the same cost, and remember, a large number of retail investors trade through these institutions who have such access. Over 90 percent of market participants have access to such services, including retail investors indirectly.
Thus, it is hard to argue that the U.S. equity market is broken as a result of the emergence of high frequency trading. Nonetheless, there is always room for targeted improvement of the current regulatory structure, and I would now like to present a few specific proposals.
First, regulators should consider mandating and harmonizing exchange-level so-called kill switched. A kill switch is a mechanism that would halt a particular firm’s trading activity when a preestablished exposure threshold has been breached, thus stopping erroneous orders and preventing any further uncontrolled accumulation of positions. This would act against a single firm.
Second, they might consider addressing the volume of order message traffic generally, which can create market instability, by establishing order-to-trade ratios, and regulators should consider charging fees for extreme message traffic in particular circumstances.
Third, regulators should consider abolishing immunity that exchanges have from liabilities for losses from market disruptions based on their SRO status, which might better align the exchanges’ incentives to limit potentially risky trading that could pose widespread operational risk.
And, I also endorse the idea, and I think it is quite important, of a much better audit trail, the CAT effort that the SEC is underway with, and I agree with Senator Warner that they should act sooner rather than later on that, because knowing what happens is the key to all of our understanding, and that audit trail will help give us knowledge that we currently do not have about how trading is actually being conducted.
In concluding my remarks, I wish to reiterate that the strength of U.S. equity markets has positively affected capital formation, and by extension, promoted job creation. Any changes in HFT regulation should be based on a factually careful assessment of abuses and regulation to fix them without harming the overall performance of our markets. Thank you, and I look forward to your questions. Chairman Warner. Thank you, Professor Scott. Mr. Solomon.