Surfing the Wave: Technology, Innovation, and Competition – Remarks at Harvard Law School’s Fidelity Guest Lecture Series
Commissioner Kara M. Stein
Nov. 9, 2015
Thank you, Professor [Hal] Scott, for that kind introduction.
Before I begin, I need to issue the standard disclaimer that you may have heard other SEC Commissioners repeat: the views that I express tonight are my own, and do not necessarily reflect those of the Commission, my fellow Commissioners, or the staff of the Commission.
I am very pleased to be at Harvard Law School this evening. I appreciate the invitation to be a part of the Fidelity speaker series. It is always a pleasure to speak to a group of people keenly interested in securities regulation and capital markets. Thanks to all of you for taking the time to be here tonight.
I have been thinking a lot recently about a subject near and dear to Professor Scott’s heart – the competitiveness of U.S. capital markets. Our capital markets here in the U.S. have provided us with significant opportunities and advantages. Internationally, they have been the most appealing and best performing markets in the world for decades.
When I think about competition and why the U.S. capital markets have thrived, I keep returning to the concept of quality. Our markets, while not perfect, have been reliable and dependable places for the allocation of capital. They have thrived not on account of their light regulatory touch, minimal compliance burdens, or lowering of standards to attract business. Rather, our markets have thrived because of their commitment to quality. That is what has made them a premier destination.
That is what I want to address tonight: maintaining this market excellence, this quality, in the face of disruption. For every innovation promising benefits, there are potential uncertainties and drawbacks. The Commission and market participants should be working together to surf this wave of innovation, rather than being overcome by it.
So, I would like to focus on recent innovations and how they have injected both excitement and new issues into the financial markets. First, I would like to talk about the migration of financial services from traditional, brick and mortar locations to virtual locations. Second, I would like to spend some time discussing the changes occurring in the asset management industry, in particular exchange-traded funds (ETFs). We need to be taking a closer look at their operation if we want the asset management industry in the U.S. to remain at the top. Finally, I want to highlight technological innovation in our market structure. It helps keep our markets at the forefront but also requires us to be vigilant about maintaining their strength and quality.
My hope after this talk is to leave you all with the same questions that I am continually grappling with at the Commission – how do we continue having the highest quality markets in the world, even while these markets are being disrupted and transformed? How do we develop a vision for positively regulating, in a world where innovation is now dominating our markets?
Being Proactive: A Competitive Necessity in the New Landscape
All across the capital markets, technology and innovation are challenging the old ways of transacting business and old ways of thinking about regulation. There is a migration underway from traditional, brick and mortar locations to virtual locations. Many of the new innovations are reimaginings of current market functions. They present the possibility of democratizing services. They may lower barriers to entry, reduce red tape and costs, shake up entrenched practices, and level the playing field for smaller businesses.
You have likely heard of many of them - robo advisors; online peer to peer lending; equity crowdfunding; and now, blockchain technology. Financial technology companies (FinTech) have emerged to challenge large banks, and we are currently riding an entrepreneurial wave in this area.
Take robo advisors. On your smart phone, you can access automated investment advice. Services range from portfolio management to asset allocation to financial planning. You never interact with a human being. Computer algorithms essentially provide customized advice to investors about how they should invest. Fees and minimum investment amounts tend to be lower than traditional financial advisors. These services are easy to use and you carry them everywhere you go on your phone.
This area of the financial services market is exploding. A recent study estimated that by 2020 there will over $2 trillion dollars being managed by robo advisors. This would comprise approximately 5.5% of all investment assets in the United States.
The Commission is now challenged with thinking through what it means to regulate a robo advisor. This concept did not even exist when most of the laws applicable to investment advisers were drafted. Most of these laws are based on the idea of a human investment adviser on the other end of the phone or sitting across the table from you. The lynchpin of investment adviser regulation is the fiduciary duty. The fiduciary duty in essence means that the adviser must avoid conflicts of interest and cannot take unfair advantage of a client’s trust. As Justice Cardozo noted all the way back in 1928, “A fiduciary is held to something stricter than the morals of the marketplace.”
What does a fiduciary duty even look like or mean for a robo advisor? The idea of a robotic entity that automatically generates investment advice certainly bumps up against what we would traditionally think of as a fiduciary. As this innovation gains more market share (as it seems poised to do), we should be asking whether these new robo advisors can be neatly placed within our existing laws. Or, do we need certain tweaks and revisions? Do investors using robo advisors appreciate that, for all their benefits, robo advisors will not be on the phone providing counsel if there is a market crash?
Clearly, if we want our markets to remain at the top, we need to embrace innovation. And FinTech clearly promises some exciting advances. But, we also need to be prepared to anticipate and ideally prevent problems before they arise. Remaining competitive requires both market participants and regulators to thoughtfully evolve with innovation, not react to it way after the fact.
Before leaving this area, I wanted to touch quickly on blockchain. Blockchain technology has been getting a lot of attention lately. It is the technology behind bitcoin, the digital currency which many of you have undoubtedly heard of. Blockchain is a database network where messages create a digital record of a transaction that cannot be changed once approved in the “chain.” Anyone on the computer network can see the details of the transactions on a public ledger. Separate and apart from its use with bitcoin, some have been recently advocating that blockchain technology could revolutionize other areas of finance. It could be used to overhaul areas like securities clearing and settlements, payment processing by banks, and cumbersome loan transactions. It has the power potentially to increase quality and facilitate trust.
While I am not advocating for the adoption or effectiveness of blockchain technology, it appears to offer potential. One can imagine a world in which securities lending, repo, and margin financing are all traceable through blockchain’s transparent and open approach to tracking transactions. That could revolutionize regulators’ approach to monitoring systemic risk in these areas, including the oversight of collateral reuse, to name just one potential use.
However, creative uses of blockchain are still in their infancy, and a lot of questions will need to be answered, including on issues related to cybersecurity. I do think regulators, academics, and market participants in the U.S. need to be constantly evaluating potentially disruptive ideas like blockchain. Can it be used to enhance the quality of our markets and investor protection? Or, is there a way it could be used to monopolize markets or undermine competition? How should this technology be best deployed? Should it be run via a public-private partnership, somewhat like the Internet? If the market begins to move toward blockchain technology, regulators need to be in a position to lead, harnessing its benefits and responding quickly to potential weaknesses.
The Commission and its fellow regulatory agencies have a unique opportunity right now to be forward thinking in regards to some of these new innovations and ensure they develop thoughtfully, with investor protection as a guiding principle. If investors have trust in the integrity and quality of these new services and products, everything else will follow, and the potential benefits can be harnessed, for both investors and financial services providers.
Competing on Quality and Innovation in Asset Management
Innovation is also changing and challenging the asset management industry. The U.S. mutual fund and ETF market is the largest in the world with approximately $18 trillion in assets under management at the end of 2014. This accounts for more than 50% of the global market for these investment vehicles. Within the Commission’s Boston Regional Office footprint alone, there are over $3 trillion dollars of mutual fund assets and almost $190 billion dollars in ETF assets. Clearly, this industry has been thriving and is an area in which the U.S. remains very strong from a competitive perspective.
Why has the asset management industry in this country remained so competitive? There are many reasons, of course. But I believe that chief among them, as I have noted throughout my talk tonight, is that investors have faith in the quality of the product. Although they may not know it, investors are protected by a law called the Investment Company Act of 1940, which ensures that there are basic rules of the road that make these products predictable. Mutual funds have allowed investors to take informed risks, all within a well-understood set of basic restrictions and protections.
This brings me to ETFs. ETFs have in some ways been a positive, competitive innovation in the markets. They have opened up an array of investment options for investors and are often more tax efficient. Yet, there are some difficult questions posed by recent market events that need to be proactively answered. Otherwise, ETFs may jeopardize the confidence that investors have in both these products and the asset management industry.
By way of background, regulation of ETFs is spread across several divisions at the Securities and Exchange Commission, not fitting neatly into any one box. Simply in order to exist, the ETF structure requires exemptive relief from several Commission rules because, absent such relief, it would violate the federal securities laws. In many ways, ETFs are regulated by exemptive order or by exception, rather than through law or regulation.
Like mutual funds, ETFs allow investors to pool money into fund vehicles that make investments in a variety of assets. Unlike mutual fund shares, which typically are only priced once per day after the exchanges close, ETF shares are traded and priced on an exchange all throughout the day. As ETFs trade, and the price of ETF shares fluctuates, large market participants may buy or sell shares if the market price deviates from the fund’s underlying securities. This is commonly referred to as the ETF arbitrage function, and it typically acts to keep the market price in line with the net asset value of the ETF.
ETFs have been hailed as innovative because of these features. And money is pouring into ETFs at record rates. This year, for the first time, global assets under management attributable to ETFs surpassed assets under management attributable to hedge funds. Many wonder whether ETFs are now poised to become even more popular than mutual funds as the retirement vehicle of choice.
However, it is increasingly apparent that ETFs behave very differently than mutual funds in our capital markets. The events of August 24 demonstrate that ETFs may act quite unusually in stressed market conditions and, frankly, break down in ways that we do not completely understand.
As background for those who are not familiar, on August 24th of this year almost half of the New York Stock Exchange listed equities had not opened by 9:40am. Many stocks opened extremely and unexpectedly low. Certain stocks dropped almost 50% and then quickly recovered, for no apparent reason. As a result of circuit breakers being tripped, there were over 1,200 trading halts that day. This means that trading in securities was suspended over 1,200 times temporarily, and over 75% of these halts were ETFs. This is a stunning number of circuit breakers tripped in one day, and it is an especially stunning number of ETFs.
It is clear that we need to think more about the limit up-limit down circuit breakers and how they work for ETFs. The circuit breakers were instituted in 2012, largely as a result of the May 2010 Flash Crash. August 24th was the first large scale test of limit up–limit down, which restricts trading in stocks when prices have dropped or jumped by a certain percentage. Limit up-limit down basically means that if a particular stock price hits the outer limit of a predetermined band - say a 5% move from the average price at which the stock had been trading for the previous 5 minutes - trading is immediately suspended for 15 seconds. It gives everyone a pause. However, August 24th revealed that limit up-limit down may not work for ETFs the way it does for individual securities and needs to be looked at closely.
I am also concerned about how everyday investors submitting stop loss orders on August 24th were affected. Basically, stop loss orders are orders to buy and sell a stock once the price of the stock reaches a specified price, the stop price. But, these “stop orders” did not stop anything – they effectively transformed into market orders on August 24th. There were numerous reports of investors placing stop orders at the beginning of the day that got converted into market orders – leaving selling investors shocked at the executed price of their trades.
As Commissioner Aguilar recently noted, the time may be ripe for reconsidering the whole ETF ecosystem, including possible rulemakings. The Commission recently issued a request for comment on the exchange-traded product space and we have received some valuable input that I hope will inform our policy choices going forward. Now is the time to be asking the hard questions about ETFs. Broadly, we should be considering whether we need new rules to address these innovative funds. At a granular level, we should be examining the roles that all of the individual players in this ecosystem play (such as authorized participants). Systemically, I am particularly focused on how ETFs trade, as compared to mutual funds, and whether the way algorithmic traders utilize ETFs poses concerns to investors placing their retirement savings in these products.
Market structure events like what happened on August 24th can affect our competitive standing. If we want our asset management industry – which is increasingly pushing into ETFs – to remain at the top globally, we cannot continue to have events that threaten investor confidence. We certainly want to encourage creativity and new product development, but we need to be mindful of consequences and the net effect of these innovations. As I mentioned earlier, the asset management industry has thrived in large part because of confidence in the product. We need to ensure that asset management continues to be an industry that distinguishes itself with its quality, including in the ETF space. We will only accomplish this by proactively addressing the issues posed by events like August 24th.
Innovation Drives Competitiveness: How Do We Drive on Our New Market Highways?
August 24 was not, however, solely about ETFs. It is only one in a series of recent events that highlights issues regarding the stability and reliability of our highly computerized equity market structure. This is the final area I want to touch on - technological innovation and the effect it can have on market structure. As we all know, there have been extraordinary advances in the technology undergirding our capital markets. U.S. markets are faster and more efficient than they have ever been. There also are more choices available to investors. Bid-ask spreads, execution, and transaction costs have generally improved. All good things for investors that have helped keep our capital markets attractive and competitive. These improvements are a result, at least in part, of technological innovation.
However, there is a flip side to this innovation. Just as improvements in technology can create competitive advantages, these same improvements can introduce new costs and risks. The financial crisis was catalyzed by “financial innovations,” such as CDOs (collateralized debt obligations) and CDS (credit default swaps). A lack of quality and transparency injected enormous uncertainty. As a regulator, the Commission needs to keep pace with these changes. It needs to foster innovation while at the same time addressing the new issues and vulnerabilities that such innovations can create.
Algorithmic trading is an area that has received lots of attention lately. Without getting into a debate over the merits of algorithmic trading – it is clear that computers have introduced new issues and challenges that can be a potential threat to the competitiveness of our markets if not understood and addressed. Algorithmic strategies are generally aimed at making a tiny profit over a large number of trades. Computer programs follow a complex set of instructions to buy and sell in ways quicker than a human trader ever could. Many argue that trading firms pursuing this strategy are providing much needed liquidity in the markets, and that these strategies have gone a long way toward tightening spreads. Others argue vociferously that algorithmic trading has added costs that the entire marketplace is paying for, and does not provide authentic liquidity.
Whatever your belief, these strategies are beholden to complex, robotic formulas. They can and do trade billions of dollars in microseconds, instantaneously and automatically. And these computer formulas lack the judgment that human traders or portfolio managers may have, especially in stressed market conditions. These algorithmic formulas employed by firms are not identical, obviously – but many firms are pursuing the same strategy in a similar way.
Recently, I compared this sort of robotic trading activity to the driverless car. What happens when you take human judgment out of the equation? Companies trying to launch driverless cars are struggling with many of the same issues that we are seeing in our capital markets. I read an article recently quoting a professor discussing how human beings cope with being at a four way stop on the roads. He observed that humans “make eye contact. On the fly, they make agreements about who has the right of way.” He then asked: “Where are the eyes in the autonomous vehicle?” Many are asking the same questions of computers and their algorithms in our markets. Where are the eyes when a computer needs to navigate an unexpected situation?
In our capital markets, we have in many ways already gone the way of the robotic, driverless car, without having a robust discussion of how we should regulate it. Estimates for total market volume attributable to algorithmic trading routinely exceed fifty percent. We are not in the testing phase.
Regulators need to get their arms around this new market structure reality for many reasons. Chief among them is that failure to do so will harm the competitiveness of our markets for years to come. Does our existing regulatory paradigm work given the new reality of algorithmic trading? Or are we shoehorning the regulation of such trading into statutes and rules that are antiquated and ill-suited for the task? How do we regulate a computer algorithm under current laws, or do we need new laws?
CFTC Chairman Massad recently proposed some ideas for regulating algorithmic trading that are worth thinking about. Should we have kill switches or message throttles for algorithms? How can we be more proactive and thoughtful in addressing a trading strategy that already accounts for a majority of total market volume? I have previously discussed the idea of greater licensing and registration for computer programmers. Is there an algo equivalent to the Series 7 exam?
Characterizations of the capital markets as being “rigged” or “broken” damages the competitive standing of U.S. markets. We run the risk of investors and market participants not trusting in the quality of our markets. Improved technology needs to be harnessed for the good of the markets, without allowing it to run roughshod over these same markets.
As I think about where the markets are being driven by innovation, I keep thinking back to the origins of the Internet and the pivotal role the United States played. Other countries certainly played a role, but the U.S. spearheaded and led the development of the Internet. The U.S. was at the forefront. And because of this leadership role, the United States has benefited immensely.
Just like the role we played in the development of the Internet, the U.S. should strive to be at the center of how the new financial market is framed and regulated. We are at a similar moment in time for financial markets. If we do not lead, someone else will. I hope that all of you will all be a part of a conversation about where the markets should be headed and how they should be regulated, as we deal with unprecedented technological change and innovation. We need the academic community to be engaged. The Commission and the public need you to ride the wave of innovation right along with us.
Thank you very much for your time and attention this evening. It has been a privilege speaking with you, and I look forward to hearing som
 See, e.g., Daniel Gallagher & Hal Scott, Can the U.S. Remain an International Financial Center?, Real Clear Markets, Oct. 1, 2015, http://www.realclearmarkets.com/authors/daniel_gallagher_amp_hal_scott/.
 Some foreign markets may be too quickly forgetting the lessons of the 2008 financial crisis and may be lulled into the mode of “competing” by reducing regulatory burdens and racing to the bottom. Not only is this a mistake for those markets, but in a highly interconnected global market, the negative impact on financial stability and investor protection can be potentially severe.
 Crowdfunding, Release Nos. 33-9974, 34-76324 (Oct. 30, 2015), http://www.sec.gov/rules/final/2015/33-9974.pdf. The Commission passed a rule last month, for the first time permitting this activity at the federal level.
 Matt Egan, Robo Advisors: The Next Big Thing in Investing, CNN Money (June 18, 2015), http://money.cnn.com/2015/06/18/investing/robo-advisor-millennials-wealthfront/index.html.
 Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928).
 Jane Wild, Martin Arnold & Philip Stafford, Technology: Banks Seek the Key to Blockchain, FT The Big Read (Nov. 1, 2015), http://www.ft.com/intl/cms/s/2/eb1f8256-7b4b-11e5-a1fe-567b37f80b64.html#axzz3qR5dW4nT.
 See Investment Company Institute, 2015 Investment Company Fact Book 7 (55th ed.), https://www.ici.org/pdf/2015_factbook.pdf.
 Data as of June 2015.
 Comm’r Kara M. Stein, Mutual Funds – The Next 75 Years, June 15, 2015, http://www.sec.gov/news/speech/mutual-funds-the-next-75-years-stein.html.
 For a list of exemptive relief orders, including ETF relief, granted since 2007 see U.S. Securities & Exchange Commission, Investment Company Act Notices and Orders, https://www.sec.gov/rules/icreleases.shtml.
 Exchange Traded Funds, Release No. 33-8901 (March 11, 2008), https://www.sec.gov/rules/proposed/2008/33-8901.pdf. The Commission proposed, but did not adopt, an ETF rule in 2008.
 An ETF’s intraday price does not necessarily track the net asset value at all times. So, market participants may buy or sell when the ETF’s price deviates from the value of the underlying portfolio holdings of the fund. In most situations, this arbitrage opportunity works to keep the ETF’s market price closely in line with its net asset value.
 Matthew Jeynes, Assets Held in ETFs Surpass Hedge Funds for First Time Ever, FT Adviser (July 21, 2015), http://www.ftadviser.com/2015/07/21/investments/etfs-and-trackers/assets-held-in-etfs-surpass-hedge-funds-for-first-time-ever-19NU9ZvgpLPPRpm4oJSy3I/article.html.
 Bradley Hope, Ryan Dezember, and Andrew Ackerman, The Man Who Took KKR’s Stock for a Ride, Wall St. J., Sep. 18, 2015, http://www.wsj.com/articles/the-man-who-took-kkrs-stock-for-a-ride-1442568781.
 Bradley Hope, Trading in Stocks, ETFs Was Halted More than 1,200 Times Early Monday, Wall St. J., Aug. 24, 2015, http://www.wsj.com/articles/trading-in-stocks-etfs-paused-more-than-1-200-times-early-monday-1440438173; Philip Pearson & Ben Polidore, Volatility Series: Trading Halts, ITG, Sept. 29, 2015, http://www.itg.com/marketing/ITG_Pearson_TradingHalts_EBupdate_20150929.pdf.
 See SEC Approves Proposals to Address Extraordinary Volatility in Individual Stocks and Broader Stock Market, June 1, 2012, http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171482422.
 Sam Mamudi, Sabrina Willmer & Annie Massa, ETF Firms Tackle Wall Street on Ways to Prevent Another Aug. 24, BloombergBusiness (Oct. 6, 2015), http://www.bloomberg.com/news/articles/2015-10-06/etf-firms-tackle-wall-street-on-ways-to-prevent-another-aug-24.
 Comm’r Luis A. Aguilar, How Can the Markets Best Adapt to the Rapid Growth of ETFs, Oct. 15, 2015, https://www.sec.gov/news/statement/how-can-markets-adapt-to-rapid-growth-etfs.html.
 See SEC Publishes Request for Public Comment on Exchange-Traded Products, June 15, 2015 http://www.sec.gov/news/pressrelease/2015-118.html, and Request for Comment on Exchange Traded Products, http://www.sec.gov/rules/other/2015/34-75165.pdf.
 See, e.g., James J. Angel, Lawrence E. Harris & Chester S. Spatt, Equity Trading in the 21st Century: An Update, June 21, 2013, at 23-24, http://www.q-group.org/wp-content/uploads/2014/01/Equity-Trading-in-the-21st-Century-An-Update-FINAL.pdf.
 See, e.g., Comm’r Kara M. Stein, Market Structure in the 21st Century: Bringing Light to the Dark, Sept. 30, 2015, http://www.sec.gov/news/speech/stein-market-structure.html.
 Matt Richtel & Connor Dougherty, Google’s Driverless Cars Run Into Problem: Cars with Drivers, N.Y. Times, Sept. 1, 2015, http://www.nytimes.com/2015/09/02/technology/personaltech/google-says-its-not-the-driverless-cars-fault-its-other-drivers.html?_r=0.
 Staff of the Division of Trading & Markets, U.S. Securities & Exchange Commission, Equity Market Structure Literature Review Part II: High Frequency Trading, March 18, 2014, https://www.sec.gov/marketstructure/research/hft_lit_review_march_2014.pdf.
 Chairman Timothy Massad, Remarks before the Conference on the Evolving Structure of the U.S. Treasury Market, Oct. 21, 2015, http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-30.
 Comm’r Kara M. Stein, Market Structure in the 21st Century: Bringing Light to the Dark, Sept. 30, 2015, http://www.sec.gov/news/speech/stein-market-structure.html.
 David C. Mowery & Timothy Simcoe, Is the Internet a U.S. Invention? – An Economic and Technological History of Computer Networking, Dec. 2002, http://faculty.haas.berkeley.edu/mowery/ba290g/internetrespol_4.pdf.