Senator Kaufman’s Final Speech on Market Structure 9/28/10

The Senator was a tireless voice for investors, and he spoke against a powefrul lobby, with nothing to gain for himself and much to lose. He served the people, and not the other way around. He is a great man.

Attaboy Captain Fantastic.




SEPTEMBER 28, 2010

Today I come to the floor one final time to talk about the integrity of our equity markets, a subject that I have made a central focus of my relatively short Senate tenure.  It is an issue that has gained increasing attention — especially since the May 6 flash crash — yet still lacks fundamental transparency, regulation, or oversight.

A year ago I wrote to Mary Schapiro, the Chairman of the Securities and Exchange Commission, to outline my concerns. Seven times since then I have come to the Senate floor to talk about the dramatic changes taking place in our equity markets, discussing obscure practices like co-location, “naked” access, flash orders, and the proliferation of dark pools.

But the most striking change has been the rise in high frequency trading, which has come to dominate the equity markets and now accounts for well over half of all daily trading volume.

My message about high frequency trading has been straightforward: the technological advances and mathematical algorithms that have allowed computers to trade stocks in millionths of a second in and of themselves are neither good nor bad. Indeed, as an engineer, I have a deep appreciation for the importance of technological progress. 

But technology cannot operate in a vacuum nor should it dictate how our markets function. Simply put, technological developments must operate within a framework that ensures integrity and fairness.  

That is why our regulatory agencies are so critically important.  Because while technology often produces benefits, it might also introduce conflicts that pit long-term retail and institutional investors against professional traders who are in and out of the market many times a day.  As Chairman Schapiro has consistently asserted, including in a letter to me over a year ago, and I quote: “If . . . the interests of long-term investors and professional traders conflict … the Commission’s focus must be on the protection of long-term investors.”

Many people have asked me why I have focused so intently on the arcane details of how stocks are traded during my short time as a Member of the Senate.  There are several reasons, Mr. President.

First, it is Congress’ job not just to look backwards and analyze the factors that brought about the last financial crisis. It is also our job to be pro-active and identify brewing problems before they put us into a new financial crisis.

Second, we simply must protect the credibility of our markets.  I’ve said time and again that the two great pillars on which America rests are democracy and our capital markets.   But there is more at stake than a structural risk that could bring our markets once again to their knees, as occurred on May 6; there is a real perceptual risk that retail investors will no longer believe that the markets are operating fairly, that there is simply not a level playing field.   If investors don’t believe the markets are fair, they won’t invest in them. And if that happens, Mr. President, we can all agree our economy will be in serious trouble. 

Third, we should have learned the lesson from derivatives trading that when we have opaque markets, disaster is often not far behind.  It is hardly surprising that high frequency trading should deserve a watchful, and possibly critical, government eye. It is simply a truism that whenever there is a lot of money surging into a risky area, where change in the market is dramatic, where there is no transparency and therefore no effective regulation, we have a prescription for disaster.  We had a disaster in the fall of 2008, when the credit markets suddenly dried up and our markets collapsed.  We had a near-disaster on May 6, 2010.  

Soon, the SEC will issue a second report on the causes of the flash crash.  I hope the SEC has moved much closer to truly understanding the dramatic changes in market structure that have taken place in the past few years, the potential ramifications of high frequency trading, and its impact on retail and institutional investors.

But this is about more than investor confidence.  The primary function of our capital markets is to permit companies to raise capital, innovate and grow in order to create jobs.  Publicly-traded companies employ millions of Americans and are at the heart of our economy. Their stock symbols should not be used simply as the raw material for high frequency traders and exchanges and other market centers more concerned with churning out trade volume than serving long-term investors and supporting fundamental company value.

Perhaps it is not surprising, Mr. President, that our IPO markets have deteriorated dramatically and only seem to work for the largest public offerings worth several hundred million dollars. Indeed, the IPO situation today is so dire that had it been the case two decades ago, many of our most famous U.S. corporations, including Dell, Yahoo, Computer Associates and Oracle, might never have been nurtured — or perhaps even born.  Many people, including the consulting firm Grant Thornton, link this phenomenon directly to the rise of high frequency trading under a one-size-fits-all set of market rules that favors efficiency of trading above all else. 

As for the Securities and Exchange Commission, I believe the SEC is still in the early stages of what I hope will be an extraordinary turnaround. After years and years of deregulatory fervor, which sapped morale and led to an egregious case of regulatory capture, we now have an emboldened agency, with a beefed up enforcement division, a serious chairman, and an invigorated staff. That was evident in last week’s hearing on the Fraud Enforcement and Recovery Act. 

The Commission must still reform the way it gathers the facts it needs to study market issues and particularly high frequency trading.  Evidence-based rulemaking should not be a one-way street in which all the ‘evidence’ is provided by those whom the SEC is charged with regulating.   We need the SEC to require tagging and disclosure of high-frequency trades and quickly implement a consolidated audit trail so that objective and independent analysts — in academia, private analytic firms, the media and elsewhere — are given the opportunity to study and discern what effects high-frequency trading strategies have on long-term investors. They can also help determine which strategies should be considered manipulative.  The recent “layering” case brought by FINRA against a high frequency trading firm was a good start, but much more needs to be done to end the “wild west” trading environment that today is eroding market integrity.

We cannot afford regulatory capture nor can we afford consensus regulation, not in any government agency, but especially at the SEC, which oversees such a systemic, and fundamental, aspect of our entire economy. Co-location, flash orders, and naked access are just a few practices that were fairly widespread before ever being subjected to any regulatory scrutiny. For our markets to remain credible — and it is essential that they do so — it is vital that regulators be proactive, rather than reactive, when future developments arise.

After a year of intense study by me and my staff, I sent a letter to the SEC on August 5, 2010 with my best summary of the market structure problems and potential solutions the Commission faces.  I will now wait for the SEC report and findings, before I add or detract from my views as expressed in that letter.

Though this work must be completed in my absence, I will continue to speak out on market structure issues long after I leave the Senate.  Because if we fail, if we do not act boldly, if the status quo prevails, I genuinely fear we will be passing on to my grandchildren a substantially diminished America – one where saving and investing for retirement is no longer widely practiced by a generation of Americans and where companies no longer spring forth from the well of capital flows that our markets used to provide.

Wall Street is a business, like any other business in America. But it is also different in an important way; it is Wall Street that gathers up the hard-earned cash of millions of Americans and allows them to invest in capital markets that have been the envy of the world. 

These markets, like all markets, will ebb and flow. But they should never be brought down by inherent structural problems, by trading inequities, or by opaque operations that shun transparency.

 Wall Street holds a piece of American capital, our collective capital, and it has a real and profound responsibility to handle it fairly.  But that entails another obligation as well:  to come to the table and play a constructive role with Congress and the SEC in resolving its current issues — especially the possibility of high frequency trading manipulation and systemic risk.  For too long, many on Wall Street have urged Washington to look the other way, to accept the view that all is fine.  If Wall Street does not engage honestly and constructively, then these issues must be resolved without their input.

And resolve them we will. The credibility of our capital markets is too precious a resource to squander; as I say every time I have the chance, it is a fundamental pillar of our nation. And if it is now threatened, Congress and the regulatory agencies will surely act.  We can fashion a better solution with industry input, not a biased solution, but a better solution, one that should benefit Wall Street in the long term; one that must benefit all Americans now.

The American people deserve no less.