By Simon Johnson
The Securities and Exchange Commission (SEC) under Mary Shapiro is trying to escape a difficult legacy – over the past two decades, the once proud agency was effectively captured by the very Wall Street firms it was supposed to regulate.
The SEC’s case against Goldman Sachs may mark a return to a more effective role; certainly bringing a case against Goldman took some guts. But it is entirely possible that the Goldman matter is a one off that lacks broader implications. And in this context the SEC’s handling of concerns about “high frequency trading” (HFT) – following the May 6 “flash crash”, when the stock market essentially shut down or rebooted for 20 minutes – is most disconcerting. (See yesterday’s speech by Senator Ted Kaufman on this exact issue; short summary.)
Regulatory capture begins when the regulator starts to see the world only through the eyes of the regulated. Rather than taking on board views that are critical of existing arrangements, tame regulators talk only to proponents of the status quo (or people who want even more deregulation). This seems to be what is happening with regard to HFT.
HFT is a big deal – perhaps as much as 70 percent of all stock trades are now done by “black box” computer algorithms (i.e., no one really knows how these work), and there are major open questions whether this operates in a way that is fair for small investors. (Disclosure: in 2000-2001, I was on the SEC’s Advisory Committee on Market Information; I was concerned about closely related issues, although market structure has changed a great deal over the past 10 years.)
The technical, “fact-gathering” activities of bodies like the SEC are of critical importance in both building an overall consensus – do we have a problem, what should we do about it – and also in creating the basis for regulatory action (e.g., the SEC does not even collect the data needed to understand how HFT contributed to the May 6 disaster). And anyone who has ever put together a relatively complicated discussion of this nature can attest that how you frame the issues is typically decisive, i.e., what is presented as the range of reasonable alternative views?
On Wednesday, the SEC will hold a “market structure roundtable” to discuss “high frequency trading, undisplayed liquidity, and the appropriate metrics for evaluating market structure performance.” But who exactly will be at this discussion?
The names of panelists for this discussion are not yet public and probably not yet final – but the preliminary list is far too much slanted towards proponents of HFT (6 out of 7 seats at the table; see Senator Kaufman’s speech for details), with hardly any representation of people in the markets (e.g., “buy side” mutual funds) who think HFT is potentially out of control or unfair. It looks very much like someone is setting up a love fest for HFT – and a boxing match with 6 tough guys against one lonely critic.
To be fair, after coming under heavy pressure from a leading member of the Senate Banking Committee over the past 48 hours, the SEC is backpedaling quickly and indicating that the panel invitations can be broadened. This is encouraging – perhaps the agency is finally overcoming its tin ear problem.
But nothing other than a balanced panel on June 2 would be acceptable. At the very least, the SEC needs to increase the panel to 10 people – 5 for and 5 against. And all the issues need to be on the table – including exactly who benefits from HFT, how much money they make in this fashion, and whether or not long-term investors (and the broader economy) really gain from such arrangements.
The SEC must understand that it has a long way to go to restore its credibility. Wednesday’s quasi-hearing is an important test and many people will be watching carefully.