In September 2015, EY hired RiskMetrics co-founder Gregg Berman a few months after his five years’ spell at the SEC. Berman had joined the US regulator in 2009 as part of SEC Chairwoman The Hon. Mary Schapiro’s initiative to bring in more people with industry, information technology and data analytics experience; Schapiro’s successor, Elisse Walter, and now current SEC Chair Mary Jo White continue to emphasise the importance of technology for uses such as analysing ‘Big Data’. Pre-crisis it had been unusual for the SEC to hire an entrepreneur, and would have seemed even more atypical as Princeton Physics PhD Berman was not a lawyer, economist or accountant. But Berman explains how “there has been a huge influx of different types of people with industry experience”.
He started in the SEC’s newly formed division of Risk, Strategy, and Financial Innovation; moved on to policy in the Division of Trading and Markets; and ended up as an Associate Director forming a new Office of Analytics and Research. Under the auspices of that new office, Berman implemented a new commission-wide system, dubbed the Market Information Data Analytics System (MIDAS), used to collect, process, and ultimately share with the public, analyses of billions of trade and order data records from our public equity exchanges.
Berman, who worked with some of the world’s largest asset managers at RiskMetrics, expanded this dialogue at the SEC and has many memories of his interactions with the industry. “We spent much time meeting hedge funds, banks and broker dealers to develop more informed rules. The big surprise for me was meeting with firms who were publicly advocating for additional rules and regulations,” according to Berman. During his time at the SEC Berman developed experience in securities regulation, market microstructure and market liquidity. Berman shared with THFJ some thoughts on latency, flash crashes, the new Regulation SCI, market liquidity, SEC proposals for mutual funds’ liquidity risk management and the rebates debate; just a small selection of the areas he advises on.
Equity Market Structure
Berman did not enter public service in Washington, DC expecting a quiet life. Just months after he joined, the ‘flash crash’ of May 2010 erupted, an analysis of which highlighted the growing complexities and interconnectedness of an increasingly electronic marketplace. “Topics such as automated algorithms, system integrity, high-speed data feeds, and general market microstructure were suddenly thrown into the limelight.” Since the flash crash of 2010, the SEC and the exchanges have adopted numerous rules and safeguards based, in part, on a joint analysis of the event by the SEC and CFTC. “Many rules and regulations try to mitigate the circumstances that can lead to such highly disruptive trading. For instance, one aspect of the ‘naked access rule’, which had been imminent before the flash crash and was subsequently adopted by an SEC vote five months after in November 2010, prohibits broker-dealers from providing their customers, which can include high-frequency traders, hedge funds, or even manual traders, direct and unmonitored access to the exchanges.
Flash Crashes of 2010 and 2015
That first ‘flash crash’ was one factor encouraging the SEC to continue its analyses of modern market structure, including practices such as high-frequency trading (HFT), in more depth. HFT is widely used in the foreign exchange, derivatives, futures, equities and Treasury markets. Additionally, “tools and techniques associated with HFT are ubiquitous. Everybody, including individuals, places and cancels orders, and trades electronically through systems that use complex routing techniques, algorithms, and advanced data feeds” explains Berman. Indeed, all of these activities can be part of trading at any frequency.
Berman thinks it is important for market participants to draw comparisons between the flash crash of August 24th, 2015, and the May 6th, 2010 flash crash, which was the subject of a (relatively short at 83 pages!) joint SEC/CFTC report in October 2010. No public report has yet been issued on the 2015 crash, but already similarities and differences are apparent. A persistent problem is that many exchange traded products, including ETFs, deviated far from fair value, just as they did in May 2010. Berman thinks that “when market makers find market conditions lead them to suddenly widen spreads or reduce their provisions of liquidity, it’s probably not the best time for ordinary investors to be trading”. There are now renewed calls for rules to ensure ETFs better reflect their constituent values, and the SEC in February 2015 set up an Equity Market Structure Advisory Committee (EMSAC), made up of market participants, academics and regulators, to discuss elements of market microstructure. But one difference between the 2010 and 2015 flash crashes was that “the link back to futures was not present this time as it was largely about individual stocks” observes Berman. Futures are regulated by the CFTC, which is, like the SEC, focused on identifying nefarious behaviour by traders, whether or not they are of the high-frequency variety. The landmark spoofing case against Michael Coscia in October 2015 concerned markets under the CFTC’s watch but ended up as a Federal criminal case, as are the Department of Justice’s charges against UK national day trader Navinder Sarao in relation to the 2010 flash crash.
EY & Regulation SCI
So far these cases have involved a small firmand an individual, perhaps because “the largest firms generally know the rules” thinks Berman, but he worries that some people in the financial industry “may not be fully educated on all of the rules and their nuances, and thus do not understand the resulting consequences of their actions.”. Yet even those who are conversant with regulations can be wrong footed by unintended consequences. Just as chaos theory posits that a butterfly could cause a thunderstorm, so, too, the smallest changes in one area can have huge ripple effects- “When firms are running multiple systems at the same time, changes to some systems can interact with other systems to generate a bad outcome, which might be a violation” cautions Berman. “Firms need to constantly re-assess systems and strategies” he advises.
As an EY Principal, Berman is now bringing to bear the experience he acquired at the SEC, and finds his hands-on work is invaluable for advising EY clients, including banks, asset managers, hedge funds, broker-dealers, market exchanges and venues, and other financial service providers. “I worked on best practices and compliance across the industry, including the types of tools and technologies needed, for micro-second trading across multiple asset classes” recalls Berman, whose early career included a stint at Larry Hite’s MINT CTA as well as co-managing a hedge fund at ED&F Man. Berman is now a type of compliance consultant, helping clients draw up internal policies, procedures, protocols and internal training programmes for employees. “The legal interpretation of security rules is one thing and the practical interpretation of the rule can sometimes be more difficult” he finds.
But more guidance is becoming available, in the form of the 743-page-long Regulation SCI (Systems Compliance and Integrity) rule which “augments and formalises many procedures for exchanges and large Automated Trading Systems (ATS)” he outlines. SCI came into force on November 3rd, 2015. Berman explains “systems have to be in compliance as of that date and SCI is about making sure registrants take it very seriously, and get senior people at all levels to govern software, integrity and backups”. Systems need to be tested regularly as careless errors in coding could cause problems and “there have been very significant fines related to these types of issues in the past” warns Berman. He recognises that no system can be robust against every possible negative eventuality, but Berman hopes “SCI encourages participants to build the systems as robustly as possible with policies and procedures to mitigate and minimise damage to yourself and markets”.
Angst over Liquidity
Market structure is another area of Berman’s focus and in fixed income markets there are many complaints about liquidity – but Berman notes “the jury may still be out on this based on studies by the Fed, including the Fed’s new liquidity blog (Liberty Street Economics)”. Still, he recognises that there is “angst about fixed income markets, including declining dealer inventories, and concerns over the Treasury flash crash in October 2014” and is keeping abreast of a whole host of new initiatives. These include the growth of new venues, such as alternative trading systems, as well as new methods for trading fixed income securities, including those that focus on buy-side to buy-side trading.
Despite the diversity of trading venues, only a small number of bond issues trade every day, and for companies with multiple issues only some of them may trade daily – meaning that some sellers may struggle to find buyers. The liquidity picture in bond markets is complicated by the number of highly customised issues, so some large asset managers are calling for more standardisation with a few, plain vanilla CUSIPS instead of hundreds of them. For the time being Berman reckons low rates make it easy for companies to raise debt and less likely that companies make changes such as streamlining bond issues.
SEC Proposals for Liquidity Risk Management
The SEC is heeding investor concerns however, and its latest proposals for mutual fund liquidity risk management illustrate how the complexity of regulation has grown.
“A typical rule was once a few dozen pages long but now they can be 500 pages or more” says Berman.
To cut to the chase, the nub of the proposal is that mutual funds may need to start quantifying position-specific liquidity, in terms of how long it may take for a fund to sell its holding. The associated requirements will create extra work.
“Some funds do all of these things, but the vast majority do not, and others don’t do any” is Berman’s 10,000 feet view. For instance even though many firms are of course monitoring liquidity for internal purposes, reporting the data to the regulator will require the involvement of general counsel and CCOs.
The associated proposal for ‘swing pricing’ would also be new for US mutual funds. Although this type of variable fund pricing is used other jurisdictions such as Luxembourg, Berman sees “significant ramifications in terms of what threshold triggers the swing pricing, how it is changed, and how the NAV of the fund itself could change due to the cost of trading”.
In contrast to some parts of fixed income markets, Berman judges liquidity in equities is typically higher for many large-cap stocks and often reasonable for smaller stocks. But for small and micro-cap stocks there are concerns about overall market liquidity as market cap declines concerns about liquidity grow and here proposals such as the two year Tick Pilot programme announced in May 2015 are aiming to test if liquidity improves when spreads are forced to be widened.
Former SEC Commissioner Luis. A. Aguilar has for some time been calling for a review of the exchange rebate model, and in November called for a pilot suspension, for the most liquid stocks. Berman thinks changes to the maker-taker rebate regime “could have big consequences for everyone including retail investors” and this view was shared by nearly all EMSAC participants in the October 27, 2015 meeting.
The notion of nominally fixed commissions, charges and rebates seems strange to Europeans who typically pay in basis points, but fixed rate charges do have a disproportionate impact on lower priced shares (which tend to belong to smaller companies including ‘microcaps’). “For a stock with a penny spread the rebate becomes a chunky amount” says Berman and he notes that some exchanges may offer bigger rebates for larger volumes. Therefore, to reduce or eliminate rebates “may widen the spread for retail investors” Berman worries, but the issue is not that simple – because there may be unintended implications for other parties, including trading venues.
Various rebate models exist. Berman explains how for most models, the party posting a quote that gets hit earns a rebate, and the party that accessed that quote pays a fee. In the inverted model, the party pays if a posted quote is hit, and that party that accessed the quote receives a rebate. There are even more models for off-exchange venues. There is an on-going debate over whether the charges and rebates should be reduced, capped, subject to separate rules – or indeed left alone – and EMSAC’s newly created Regulation NMS sub-committee may report further on this in 2016.