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White: Equity Markets Offer Lessons for Treasury Market Regulation

In a recent speech, SEC Chair Mary Jo White suggested that equity market regulation could provide a roadmap for addressing market structure issues and regulatory gaps in the Treasury markets. She noted that the significant volatility in the Treasury markets on October 15, 2014, brought to light “the growth of high-speed electronic trading, with associated shifts in the nature of market participants and the ways that they both demand and supply liquidity.” She compared the events to the “Flash Crash” of May 6, 2010, which she called “a catalyst for reform” and which “helped crystallize the attention of both market participants and regulators on priority issues.”

White described the exiting regulatory regime for Treasury markets:

Under existing laws, the Treasury Department has authority to write rules for transactions in government securities by government securities broker-dealers. The SEC, federal bank regulators, and FINRA, in consultation with the Treasury Department, are authorized to issue sales practices rules. The antifraud provisions of the federal securities laws apply to government securities broker-dealers, and enforcement and examination authority resides with the SEC, FINRA, and the appropriate bank regulator. And Treasury futures are regulated by the CFTC.

However, White argued that “to be effective, regulations must continually be evaluated in light of current conditions.” White acknowledged that equity market regulation could not simply be “imported” to Treasury markets, but she suggested that “the SEC’s years of experience with electronic equity markets should be helpful in assessing certain aspects of the structure and regulation of today’s interdealer Treasury market for the most recently issued ‘on-the-run’ Treasury securities.”

White argued that “operational integrity is an essential foundation of electronic markets” because “problems with one participant’s systems can lead to market disruptions that can harm many other participants.” She highlighted the SEC’s Market Access Rule which “requires firms that either have market access themselves or provide market access to others to implement better controls to manage the financial, regulatory, operational, and other risks of such access.” Further, she noted that the SEC staff is “developing a recommendation that would enhance the Commission’s information on how firms design and use their algorithms,” and that the CFTC staff is conducting a similar initiative.

She attempted to put instances of “transitory volatility” such as the Flash Crash and the October 15 events into perspective by arguing that such “events occur on a daily basis among the more than 8,000 equities that trade on U.S. equity exchanges.” However, “a high-quality market structure should help minimize” such events. Existing tools such as limit up/limit down and market-wide circuit breakers attempt to address the supply side of this volatility, but White stated she has asked the SEC staff to develop an “anti-disruptive trading rule” to focus on the demand side where “the use of aggressive, destabilizing trading strategies in vulnerable market conditions could be seriously exacerbating price volatility.” Such a rule “needs to be carefully tailored to apply to active proprietary traders in short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive short-term trading strategies is highest.

White also addressed the registration of intermediaries and traders. She noted that when the SEC adopted a regulatory structure for ATSs in 1998, it excluded venues trading solely in government securities “because of the joint regulation of government securities broker-dealers by the Commission, U.S. Department of the Treasury, and federal banking regulators,” despite the similar issues raised by these venues. However, White suggested that it may be time to reassess that decision. White highlighted the principle trading firms which account for between 51 and 58 percent of trading volume in Treasures and suggested that regulators should “seriously reevaluate” the regime that does not require these traders to register.

She noted that the SEC staff is looking at expanding ATS disclosure, and suggested that regulators should similarly consider expanded disclosure for Treasury market trading venues and examine the “significant dealer-to-customer segment of the cash Treasury market” where there is currently no post-trade transparency. Additionally, she argued that data sharing between regulators and across trading venues “is essential for the success of all of our other efforts.”