SEC’s Gallagher: Market regulation overhaul needed

CNBC interviewed SEC Commissioner Dan Gallagher Wednesday at the Securities Traders Association annual Market Structure Conference in Washington.

Gallagher has previously dismissed claims the stock market was rigged, noting that electronic trading has resulted in lowered transaction costs, improved liquidity, greater market speed, more efficient price discovery, reduced volatility and increased market access.

In this June 14, 2011 photo, Daniel Gallagher, nominee for Commissioner of the Securities and Exchange Commission, listens during a Senate Banking Committee hearing on Capitol Hill in Washington.
Andrew Harrer | Bloomberg | Getty Images
In this June 14, 2011 photo, Daniel Gallagher, nominee for Commissioner of the Securities and Exchange Commission, listens during a Senate Banking Committee hearing on Capitol Hill in Washington.

However, Gallagher was very vocal about two specific issues:

1) The laws created to regulate the equities market over the past 40 years have not evolved to match the way the market currently operates.

2) The fixed-income market is more thinly traded than many think and could easily suffer from a "liquidity crisis"; the method by which bonds are priced is too opaque and needs to be overhauled.

Gallagher acknowledged SEC Chair Mary Jo White has made similar comments about the need to look at aspects of stock market structure in a June speech, but he seemed outright impatient that nothing has been done so far and during the CNBC interview he clearly ramped up the rhetoric.

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Gallagher reiterated it is time for the SEC to conduct a "holistic review" of the equity markets. He highlighted three specific areas:

a) Reg NMS, the 1974 SEC regulation that opened up competition among stock exchanges and aided the development of high-speed trading.

Gallagher has been critical of Reg NMS in the past, claiming it has created many unintended consequences. But he has become more vocal of late, and in our discussion he has insisted Reg NMS itself has played a role in the markets current disjointed nature (11 exchanges, 40 dark pools, etc).

He was particularly critical of the "trade-through" rule, which requires that all exchanges execute trades at the best possible price. This sounds reasonable on paper, but the crazy-quilt system that has been created to connect all the exchanges to each other has created numerous operational difficulties and technological points of failure.

Gallagher instead proposes that exchanges be required to adhere to a broad "best execution" rule, which in addition to price would include considering the number of markets trading the security, the size and type of the transaction, and the terms and conditions of the order as communicated to the firm.

Gallagher also insisted the SEC should focus on the responsibility of broker-dealers to adhere to best execution practices, rather than focusing solely on exchanges.

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b) The Self-Regulatory Organization (SRO) model by which stock exchanges regulate themselves. Gallagher questions whether exchanges should regulate themselves at all, not because they are incapable, but because over 35 percent of all stock trading today occurs in Alternative Trading Systems (ATS) like dark pools that are largely unregulated.

The rules that apply to exchanges do not apply to these dark pools; Gallagher insists that the heavier regulatory burdens exchanges operate under put them at a competitive disadvantage and that it is time to examine whether all trading participants should be brought under one regulatory scheme.

c) The Securities Information Processor (SIP) which consolidates and disseminates market data. Each SIP is currently controlled by an affiliate or subsidiary of one of the exchanges.

Gallagher points out the lack of an alternative system to disseminate market data has created a single point of failure for the system. In August 2013 the failure of the NASDAQ SIP led to the suspension of all trading in NASDAQ equities for most of the day.

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The market, however, has provided an alternative: so-called "direct feeds," which provide top of the book data to traders for a fee. The direct feeds provide real-time data; SIPs, by contrast, consolidate transaction data from all exchanges before being disseminated. As a result, the SIP data lags by several microseconds behind the direct feeds.

This has created complaints that those who pay for access to the faster direct feeds have trading advantages over those that do not.

Gallagher is not happy about this, but insists that the main problem is that the SIP, which relies on a single "utility" model (all information in one source) is outdated; a 1970s-era relic.

He says the SEC should consider creating market competition for consolidated data. The SEC could, for example mandate that exchanges make their direct feeds available, for a fee, to third-party data vendors, who can then aggregate the last-sale prices. Fixed income: We are courting disaster.

Despite the issues in the way equities trade, Gallagher made it clear he is perhaps more concerned about the market in fixed income. He insists the fixed-income market has an "asymmetry of information," that is, traders have distinct advantages that often result in higher prices for retail investors.

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The desperate search for yield has driven investors into opaque, thinly traded corners of the bond market, including high-yield. Gallagher is very worried that some events (he specifically mentioned a sudden rise in interest rates) will create havoc in the bond market.

This worries Gallagher, since the SEC is the primary regulator for bonds in the non-governmental market (corporate bonds). Gallagher believes these markets are too opaque and wants more price transparency. He also wants more electronic trading.

This is a great idea, but the truth is most corporate bonds are bespoke: They are individually created. If they are to be able to trade electronically, some standardization is necessary, and here Gallagher believes the SEC can help.

But the industry has to act as well: There needs to be a standard set of terms for corporate bond contracts, for example.

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Easy in principle, but the truth is that much of the dealer community greatly benefits from opaque markets, since opacity creates wider bid-ask spreads and hence greater profits.

As part of the process, Gallagher wants much more information made available to retail investors about how bonds are priced and their cost to investors. He figures that if the public knew how opaque these markets still are—particularly compared with equities—there will be an outcry for change.

A potentially bigger problem is a lot of broker-dealers have gotten out of the bond business, and those that are left have far fewer bonds in their inventories. Much of this is because of the desire to get "risk" out of the banking system in the wake of the financial crisis, but Gallagher insists this has created the opposite problem—because the market has fewer participants than before, it is at even greater risk of a liquidity crisis.

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Gallagher also says the SEC needs to reorder its staffing priorities. The office that oversees the equities and options market has over a hundred SEC staffers. The office that oversees municipal bond trading has just six employees. The SEC has 0.5 employees (a half a person, seriously!) focused on the corporate bond market.

Strange, eh?

Bottom line: Migrating from over-the-counter bond markets to more efficient electronic markets won't be easy. But it's surely better than having some kind of disastrous liquidity crunch.

If and when that liquidity crunch occurs, guess what happens next? Congress will have hearings. Fingers will be pointed. And you can bet that someone will propose mandating that all corporate bonds be traded on electronic exchanges.

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Sound crazy? They already did it!

After the financial crisis in 2008, Congress mandated that swaps be executed on electronic exchanges as part of the Dodd-Frank regulations.

Finally, Gallagher again excoriated Dodd-Frank for the mountain of regulations it has dumped on the SEC and the markets. Four years after that legislation, the SEC is only halfway through the rule-making process.

He estimates at the current pace it will take another five years at least to complete all the Dodd-Frank regulations.

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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