The SEC as Financial Stability Regulator.

• Author: Allen, Hilary J.

1. INTRODUCTION II. FINANCIAL STABILITY REGULATION III. THE SEC AND FINANCIAL STABILITY REGULATION A. The SEC as Financial Stability Regulator B. Legislative Basis for the SEC's Financial Stability Mandate C. Competing Mandates IV. EQUITY MARKET STRUCTURE REGULATION IN HISTORICAL CONTEXT V. CASE STUDY: HIGH FREQUENCY TRADING A. High Frequency Trading and Investor Protection B. High Frequency Trading and Capital Formation C. High Frequency Trading and Financial Stability D. The Case for Prioritizing Financial Stability E. Market Structure Reforms Related to High Frequency Trading F. SEC Communications Relating to High Frequency Trading VI. ADOPTING A FINANCIAL STABILITY-INFORMED APPROACH TO HIGH FREQUENCY TRADING REGULATION VII. CONCLUSION I. Introduction

   After the financial crisis of 2007-2008 (the Crisis), regulators around the world adopted the pursuit of "financial stability" as one of the foremost goals of financial regulation. (1) However, the ubiquity of the goal belied a lack of consensus about how regulators should approach financial stability, and that lack of consensus persists today. This Article takes an expansive view of financial stability regulation, arguing that such regulation should seek to prevent disruptions to both financial institutions and markets, if such disruptions would have negative consequences for the broader economy. Because the Securities and Exchange Commission (SEC) has much more experience with the securities markets than other US financial regulators, the SEC is the agency best positioned to ensure the robustness of those markets. The SEC can therefore make a significant contribution as a market-oriented financial stability regulator--even if other forms of financial stability regulation might be best left to prudential regulators like the Federal Reserve.

   Private participants in the securities markets have neither the incentives nor the ability to promote financial stability (a collective good), (2) and so only a government body can work to ensure that the securities markets are robust to shocks, and minimize the likelihood of shocks occurring in the first place. If the SEC fails to take on this role, we cannot expect any other government agency to fill the lacuna. While the Financial Stability oversight Council (FSOC) was created to address threats to the stability of the financial system, it is, at its core, a committee that is designed to leverage the expertise of its member agencies rather than performing extensive regulatory functions itself. Other than the SEC, there is no regulatory agency represented on the FSOC that has extensive experience with the securities markets. (3) And there are certainly developments in the securities markets that raise financial stability concerns--this Article will focus in particular on the increasing prevalence of high frequency trading (HFT) in the equity markets.

   HFT is an umbrella term for a variety of different automated trading strategies; their common characteristic is that the computer algorithms that make the trading decisions are designed to hold assets for only a very short period of time. HFT now accounts for more than half of all trading in the U.S. equity markets, (4) and while the practice certainly affords benefits in terms of reducing the time and cost of executing trades, it also increases the complexity, interconnectedness and opacity of the equities markets. (5) Events such as the "Flash Crash" in May 2010 have alerted regulators to HFT's potential to both generate and transmit shocks through the financial system: the potential threats that HFT poses to financial stability (as well as to investors and capital formation) will be explored in detail in this Article. Of course, high frequency traders do not trade exclusively in the equity markets (i.e. the secondary trading markets for listed stocks); (6) there is an almost limitless list of assets that HFT firms will trade, including a multitude of derivatives instruments. However, this Article will focus on the equity markets.

   The SEC is currently considering how to reform its regulation of the equity markets in light of the rise of HFT and other developments, a project that began in earnest with the issuance of a "Concept Release on Equity Market Structure" on January 14, 2010 (the Concept Release). (7) Although some reforms have been implemented since that time, the project of market structure reform is nowhere near complete. To the extent that the SEC is planning to promulgate further rules addressing HFT and the equity market structure more generally, such rules can be said to be in the "preproposal period" (i.e. the time prior to the proposal of any rule in the Federal Register). As Krawiec notes, the preproposal period is "a time period about which little is known, despite its importance to policy outcomes ... the need to produce a proposed rule that is ready for comment pushes much regulatory work to this early stage of the rule development process." (8) This Article seeks to provide some insight into the preproposal stage of the market structure reform project by considering the testimony, public statements, speeches, and press releases that have been disseminated on the subject of HFT by the SEC, its Commissioners, and its staff. (9)

   The author reviewed and manually coded 107 such documents, all published between January 2010 and January 2017. A close reading of these speeches, public statements, press releases, and testimony revealed that the stability of the equity markets was indeed an important goal for many of those who held key SEC positions between 2010 and 2017. (10) Unfortunately, there is no unambiguous legislative directive for the SEC to pursue financial stability as a regulatory objective, (11) and it is therefore quite plausible that under the T rump administration, the SEC might abandon the concern for market stability that was expressed during the Obama administration. Such a course of action would be highly problematic: if the SEC were to choose not to address financial stability concerns, this would leave the financial system as a whole more exposed to systemic risks posed and propagated by the equity markets. This Article, therefore, urges the SEC to continue to focus on financial stability in general, and the threats that HFT poses to financial stability in particular--while also recognizing that this focus on financial stability will need to be balanced to some degree with the potentially competing mandates of protecting individual investors and promoting the formation of capital in the short-term.

   The remainder of this Article will proceed as follows. Part II will introduce the key concept of "financial stability," and its various interpretations. Part III will then articulate why and how the SEC should act as a financial stability regulator. Part III's argument is reasonably high-level and abstract: the remainder of the Article situates the theoretical argument in a more concrete context by considering how the SEC can promote financial stability through its market structure reform project. Part IV discusses the market structure regulation that has been implemented to date, then Part V elaborates on HFT: a major structural change to the equities markets with which the SEC is grappling. Part V considers the issues raised by HFT through the lenses of investor protection, capital formation, and financial stability before analyzing the SEC's communications on the subject. Encouraged by the depth of commitment to financial stability evinced in these communications, Part VI considers some of the implications that flow from the SEC adopting a proactive financial stability perspective when regulating HFT. Part VII concludes.

2. Financial Stability Regulation

   Despite the ubiquity of the term "financial stability," there remains a surprising lack of clarity about what "financial stability regulation" is seeking to achieve. (12) Some might assume that "financial stability" connotes stasis and ossification of the financial markets--adherents of such a viewpoint might resist financial stability regulation as seeking to freeze all risk-taking within the financial system. However, this Article argues that a stable financial system can still be dynamic, and, indeed, participants within that stable financial system can and should falter at times: "[disturbances in financial markets or at individual financial institutions need not be considered threats to financial stability if they are not expected to damage economic activity at large. In fact, the incidental closing of a financial institution, a rise in asset-price volatility, and sharp and even turbulent corrections in financial markets may be the result of competitive forces, the efficient incorporation of new information, and the economic system's self-correcting and self-disciplining mechanisms." Financial stability regulation is implicated only to the extent that problems with the financial industry have the potential to harm the broader economy.

   Others treat financial stability as synonymous with the avoidance of systemic risk. However, as I have argued in the past, the concepts of "financial stability" and "systemic risk" are not simply two sides of the same coin. A narrow consideration of systemic risk can limit regulatory focus to the financial industry itself, whereas a concern for financial stability indicates a focus both on and beyond the financial industry. (14) To elaborate, Steven Schwarcz has proffered one of the most cited definitions of "systemic risk," which he defines as:

   the risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility. (15)...