Critical Imbalances in Our Stock Market

The only way to restore confidence in our markets is to reinstitute time-tested rules on short selling and make certain that the new market structures and trading mechanisms are understood and properly regulated.
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The record-setting volatility in U.S. stock markets over the past two weeks is a clear distress signal. Our historically free, fair and credible markets are in danger of losing the support of individual American investors and investors from the rest of the world. With the advent of new technologies and regulatory improvements in the markets of other countries, investors of all kinds are questioning just how fair and transparent U.S. markets really are, and are actively exploring their alternatives.

Although this recent market rollercoaster has been largely attributed to Washington's partisan gridlock, the truth is not that simple. Several adverse developments in recent years have created critical imbalances in our stock markets. First among them is the explosion of unregulated High Frequency Trading (HFT). Second is our evolution from very few stock exchanges to a fragmented structure of many markets and "dark pools," where trading is done outside any exchange. Third is the removal of historically-proven controls on predatory bears.

HFT got its start in 2001 when the SEC ruled that stock prices, instead of rising or falling by 1/16 of a point as they had in the past, would henceforth be decimalized and denominated in pennies -- 1/100 of a point. Over the next few years, aided by advances in computer technology, HFT took off. Sophisticated traders now use computer algorithms to execute thousands of trades in less than a second. In fact, over 50 percent of all trades in our markets are now done using HFT. This isn't your father's stock market.

Working to get the SEC and the Commodities Future Trading Commission to rein in HFT was one of my highest priorities when I was in the Senate. Because of HFT's speed and complexity and the growth of unregulated markets, the SEC and CFTC know very little about its effects. This lack of meaningful oversight is a frightening parallel to what happened with derivatives during the financial meltdown of 2008.

I asked for a number of safeguards, including monitoring conflicts of interest to ensure that retail investors were being treated fairly and creating a consolidated audit trail to make it easier for regulators to investigate unusual securities trading activity. An audit trail could have prevented the "flash crash" on May 6, 2009, when the market fell 900 points in minutes. The commissions took five months to come out with a report on that event, and still left many questions unanswered.

The second change that exacerbates volatility is the fragmentation of U.S. markets. The SEC had some good reasons to approve of "Alternative Trading Systems," which allowed non-exchange trading venues that matched buyers and sellers of large blocks of shares, but that approval had unintended consequences. Trading that was once transparently done on the floor of an exchange can now be done in a "dark pool."

The SEC encouraged our current National Market System as a way to increase competition among exchanges. Again, there were unintended consequences. Trading venues have increased from two to over 50, and the fight for market share has led to questionable practices, including liquidity rebates (paid by exchanges to cooperating traders), flash orders (some traders get to see them before others) and other inducement arrangements with broker-dealers and other market participants. Anyone who says the average investor is getting the same deals as big traders is living in fantasyland.

The third problem not only increases volatility but also is responsible for large losses. Short selling is when you sell a security you do not own, hoping it will decline in price so that you can make a profit. Until 2007, a trader could sell a stock short only on an uptick in its price. Unwisely, that year the SEC discarded the uptick rule. It also watered down a rule that said that if you did not own the stock you sold, you had to borrow an equivalent amount. Many believe that manipulative "naked" short sellers (traders who sold short without any borrowed stock) helped drive Bear Stearns and Lehman Brothers into the ground.

I led a bipartisan group in the Senate that called on the SEC to reinstate the uptick rule and banish naked short selling. To date, the agency has done nothing to reinstate the old rules, and regulators are years away from establishing a consolidated audit trail. They have made little effort even to understand HFT, much less impose new rules. As for what happens in dark pools, they -- and any investor outside of them -- don't have a clue.

Before we lose our position as the world's leading financial center, we must restore confidence in our markets. The only way to do that is to reinstitute time-tested rules on short selling and make certain that the new market structures and trading mechanisms are understood, properly regulated and working for the benefit of all investors.

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