Lighting Our Capital Markets

I am so pleased to be with you today [July 11, 2017]. We all share an interest in ensuring that our markets are healthy. Strong and resilient markets are vital to having a strong and resilient economy.

Before I go further, let me pause to say that I am speaking today as an individual Commissioner and not on behalf of the SEC as a whole.

I was thinking last week about speaking with you, and I ran across an article about deep water corals. [1] Somehow, despite the low light environment of the deep ocean, corals that live hundreds of feet below the water’s surface also manage to glow in brilliant shades of orange and red.

Scientists have known about these for a while but were puzzled by the light display. Where do they get the energy for the bioluminescence? And why would the corals expend the energy in the form of a light display?

The colors are nice to look at, but what’s in it for the corals? Well, these scientists think they have the answer, and its part of a delicate ecosystem that has evolved to foster the needs of both the coral and the algae that provide the coral with food.

It turns out that the light from the corals nurtures the algae, and the algae feed the corals. The problem is, at these depths, the light is mostly blue and wouldn’t, on its own, effectively reach the algae. So these corals have evolved to absorb the available blue light. They then emit warmer colors for the algae—orange and red.

This ecosystem thrives in beautiful symbiosis.

So, you’re thinking—what a nice story, but what does this have to do with anything? I believe there is similar relationship—a symbiotic one—at work in our capital markets.

Over the past twenty years, improvements in technology and communications have dramatically expanded investment opportunities. They have also reduced investment costs. The change has been extraordinary.

And the search for a competitive edge continues to drive the rapid adoption of technology in the capital markets.

And that has caused dramatic changes in securities trading. Meanwhile, one consequence of all this innovation is that our markets have become more complex.

All of the changes have led to an active debate about the state of our markets. Are they serving investors? Are they serving companies? Are they healthy?

Some have suggested that we cannot meet the needs of both those who need capital and those who have capital at the same time.

Often this line of reasoning comes with the implicit suggestion that we should be prioritizing the needs of issuers over investors.

The argument goes like this: the information companies provide to investors is a heavy burden on those needing capital. This burden should be reduced or eliminated, and it will reduce the cost to companies.

Other times the argument is that investors are simply inundated with irrelevant information. And accordingly, we should reduce disclosures so that investors are not overwhelmed.

But ultimately, the argument is that American jobs and American public companies would be more plentiful if the information provided to investors was reduced or investor protections were scaled back.

I believe this entire line of reasoning reaches the wrong conclusion. Why? Because it starts with the wrong premise.

If you start with the premise that the capital markets are a “tug-of-war,” with investors on one side of the rope and issuers on the other, then it is natural to see the burdens of one and the benefits of the other as being part of a fundamental tradeoff.

But the capital needs of issuers and the provision of capital by investors are not a zero-sum game.

In fact, I would argue that creating a healthy ecosystem for all market participants benefits every participant.

In effect, our capital markets thrive through symbiotic interactions between companies and investors.

Investors and the companies they invest in need each other. Both do better when the needs of both are addressed.

This afternoon, I want to talk about how we can keep the markets healthy for both issuers and investors, by taking into account their respective needs.

Let’s start at the beginning with the primary market.

Over the last few years, there has been a marked shift in how investors provide capital, and in how companies seek capital in the primary markets. These markets are where securities are issued in exchange for investment dollars for the first time.

From 2009 through 2014, investors supplied nearly $17 trillion in primary capital—providing capital directly to companies in exchange for debt or equity securities. [2] And the overall amount of money raised has grown steadily.

However, during this same time period, the amount of capital raised in the private markets actually outpaced the amount raised in the public markets. [3] For example, during 2014, for every investor dollar raised in the public market, nearly $1.50 was raised in the private markets. [4]

This represents a profound shift in how companies obtain needed financing, and in how investors provide that financing.

After the Great Depression and the passage of the Securities Act in 1933, most companies accessed the U.S. capital markets through an initial public offering or IPO. In exchange for an investor’s capital, a company provided the investor with certain required disclosures.

Now, some 80 years later, many companies communicate with investors and access their capital without ever conducting an initial public offering or even registering the underlying investment.

As a result of changes in both the law and regulations, private companies may now solicit investors and raise the capital they need in transactions outside of the view of the public.

At the same time, there currently is an abundance of capital, which private companies are able to tap into and use to remain private for longer. These non-public companies are accessing private debt and private equity capital to fund their operations and growth.

In addition, many small companies are more and more likely to be acquired, instead of going public. In an era of low interest rates, debt financing is actually an economically feasible way for a company to fund its growth by purchasing smaller companies.

Put simply, how companies are seeking capital has changed and these changes have effects on our economy.

What are the impact of these changes? One impact is a reduction in the aggregate amount of information available to the entire capital marketplace. On the whole, our markets are less transparent.

Why? Because this move to the private market limits the amount of information provided to all investors about a wide variety of companies. Public companies are required to provides certain information at certain intervals. The entire market ecosystem relies on this information. Let me emphasize that—the entire market ecosystem, including private companies and their investors, relies on this information.

Investors in the secondary market use it to determine what price they should pay for a company’s shares. Investors also use the price discovery available in the public markets to determine the value of private companies.

What happens to the capital-raising ecosystem when there is insufficient information to support price discovery? And is price discovery in the private space being artificially supported by information publicly available from reporting companies in the public realm? If so, is a system that facilitates such free-riding by private companies sustainable? [5] Will liquidity drain out of the system? Does the entire ecosystem collapse?

The flow of credible, relevant, and reliable information is of paramount importance to a healthy capital-raising market. This information flow is critical for supporting informed investment decisions and facilitating capital formation. But the flow of information is equally critical to a well-functioning secondary market.

As you all know, the secondary markets have also been undergoing tremendous change.

The secondary markets in the United States are extremely competitive. Not too long ago, on the trading floor, some traders even competed on height, with some even wearing platform heels to ensure that that their hand signals could be seen and their verbal outcries heard by other traders.

However, hand gestures largely have been replaced by flashes of light. The latest frontier, high-speed trading, continues to approach the bounds of what is physically possible. Some traders and firms use microwave dishes, some use fiber optics, and others co-locate with trading centers to shave off tiny fractions of time (one-millionth of a second) in what is seemingly an all-out war with physics.

Immense amounts of data flow from the Midwest to the East Coast as traders arbitrage between the futures market and the equities market.

Algorithmic trading and sophisticated mathematical models have replaced the hustle and bustle of Wall Street. In effect, trading no longer has a physical address.

Though many have argued over both the positive and negative aspects of these changes, it is hard to dispute this new reality is here and has contributed to some new information disparities.

For example, more and more trading occurs on dark venues where traders post non-displayed orders.

It is estimated that dark pools now execute an estimated fifteen to seventeen percent of all trades. [6] What effect is this having on overall price discovery?

Non-transparent rebates and payments for order flow are also affecting the capital markets. Are the trading strategies they incentivize having a positive or a negative effect on the market?

In addition, opacity in both order routing and execution may be masking other behaviors, such as conflicts of interest, that may distort the market.

As some SEC enforcement actions have detailed, conflicts of interest between brokers and investors can arise when brokers prefer their own dark pool over other venues.

Considering all of these factors, how do we ensure that new technology can actually help keep our capital markets efficient and fair so that they can remain the gold standard for the world?

How do we ensure that the connections between those seeking capital and those providing capital are not conceptualized as a zero-sum game?

The Commission has long been concerned about the health of the U.S. capital markets, focusing on both their efficiency and their integrity. Without strong and resilient primary and secondary markets, our Nation’s economy cannot grow and thrive.

And information is key to the health of the capital market ecosystem. Investors need information and data in order to make informed investment decisions. If they don’t have it, they won’t invest or they will make poor investment decisions. This in turn will impact our businesses’ ability to innovate and create jobs.

This year, I would like the Commission to move forward on market structure initiatives that improve the information environment and the strength of our capital markets. This is central to the long-term health of our markets and underlies all other market structure issues.

For example, I hope that we can prioritize improvements to disclosures that provide information about the routing and trading practices of brokers.

In 2016, the Commission proposed some new disclosures to help investors understand how their orders were routed. [7]

In 2015, the Commission also proposed increasing the amount of information that dark pools and other trading venues provide to investors. [8]

I hope we can finalize some of these proposals.

Moreover, I believe that the Commission needs to consider what data and information should be provided in the context of our country’s rapidly growing private markets to either investors or the marketplace as a whole.

I believe that more transparency can provide the right incentives for the private market to compete with the public market, and ultimately foster the capital transfers necessary for a healthy capital formation ecosystem.

Improvements in transparency in the public and private markets, will not only empower investors to make more informed investment choices, but will contribute to the overall health of the entire ecosystem.

As former New York city mayor Michael Bloomberg recently stated, “Increasing transparency makes markets more efficient and economies more stable and resilient.” [9]

Why? Because high quality, relevant, and reliable information ensures that those seeking capital and those providing capital are symbiotic, and they are connecting appropriately for the benefit of both.

Thank you for inviting me to speak with you this afternoon. I look forward to working with all of you to keep our capital markets the most vibrant, liquid, and resilient in the world.

Endnotes:

1Joanna Klein, In the Deep, Dark Sea, Corals Create Their Own Sunshine, NYT (July 7, 2017); see also Edward G. Smith, Cecilia D’Angelo, Yoni Sharon, Dan Tchernov, Joerg Wiedenmann, “Acclimatization of symbiotic corals to mesophotic light environments through wavelength transformation by fluorescent protein pigments”, Proc. R. Soc. B 2017 284 20170320; DOI: 10.1098/rspb.2017.0320. Published 5 July 2017, available at http://rspb.royalsocietypublishing.org/content/284/1858/20170320.(go back)

2Scott Baugess, Rachita Gullapalli, and Vladimir Ivanov, Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009-2014 (October 2015), available at https://www.sec.gov/dera/staff-papers/white-papers/unregistered-offering10-2015.pdf.(go back)

1Id.(go back)

4Id. (“In 2014, registered offerings accounted for $1.35 trillion of new capital compared to $2.1 trillion reported raised through all private offering channels.”).(go back)

5Elisabeth de Fontenay, The Deregulation of Private Capital and the Decline of the Public Company, 68 Hastings L.J. 445-502 (2017), available at http://scholarship.law.duke.edu/faculty_scholarship/3741.(go back)

6John Polise, A Bridge too Far: A Critical Analysis of the Securities and Exchange Commission’s Approach to Equity Market Regulation, 11 Brook. J. Corp. Fin. & Com. L. 285 (2017), available at http://brooklynworks.brooklaw.edu/bjcfcl/vol11/iss2/3.(go back)

7Disclosure of Order Handling Information, Securities and Exchange Commission, 81 Fed. Reg. 49432 (July 27, 2016), available at https://www.gpo.gov/fdsys/pkg/FR-2016-07-27/pdf/2016-16967.pdf.(go back)

8Regulation of NMS Stock Alternative Trading Systems, 80 Fed. Reg. 80998 (Dec. 28, 2015) available at https://www.gpo.gov/fdsys/pkg/FR-2015-12-28/pdf/2015-29890.pdf.(go back)

9Recommendation of the Task Force on Climate-Related Financial Disclosure, Financial Stability Board (June 29, 2017) available at http://www.fsb.org/wp-content/uploads/P290617-5.pdf.(go back)