Any changes to the US equity market structure should be as a result of deliberate and data-driven studies instead of a knee-jerk response to a current Wall Street best seller, according to industry members speaking before the US Senate today.
The Senate’s Permanent Subcommittee on Investigations hearing, ‘Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in US Stock Markets’, is taking place this morning, seeking industry feedback on how to restore confidence to US eqity markets.
“While our current equity market structure is not perfect, I believe that it is by far the fairest, most efficient and most liquid market in the world,” said Joseph Ratterman, CEO of exchange operator BATS Global Trading.
Investors, including institutional investors, have seen dramatic reductions in order-execution costs over the past decade due to the various market structure reforms mandated by regulators, he adds.
As examples, he cited Vanguard which stated in 2010 that its trading costs have declined to 35% from more than 60% over the past 10 to 15 years, economist studies showing the spreads of NYSE- and Nasdaq-listed stocks dropped more than four cents and two cents respectively and a brokerage research note that concludes that implementation shortfall costs decreased to 40 basis points (bps) from 45 bps between the third quarter of 2009 and fourth quarter of 2013
“However, because it is a complex ecosystem, policy markets need to be mindful of the potential unintended consequences of sudden, significant changes,” advised Ratterman.
Many of the conflict of interest issues in the equities market that ‘Flash Boys’ author Michael Lewis brought into the public discourse can be traced to the Securities and Exchange Commission’s (SEC) 1975 decision to establish a national market structure (NMS) that encouraged competition by letting exchange members route orders to other exchanges, according to Ratterman. The SEC continued to refine its NMS model in the 1990s with the introduction of its order handling rules and Regulation Alternative Trading System (ATS) followed by the introduction of decimal-based quotes and Regulation NMS in the following decade.
As a result, the US equities market is a complex ecosystem in which technological innovation outpaces regulatory review and reform, he added.
Lions, tigers and bears
There is much regulators and industry participants can do to allay investor concerns over alleged conflicts of interest, such as broker-dealers basing their order-decisions on exchange rebates and their uses of predatory order types and direct market feeds, said Ratterman.
“I believe these potential conflicts of interest can be, and generally are, managed by vigorous oversight within broker dealers, and can be supplemented through additional trading transparency as well as oversight and enforcement by the Financial Industry Regulatory Authority and the SEC,” he said.
One potential solution to address conflicts of interest in order-routing would be to have ATS operators make their confidential Form ATS operating-report filings public as well as providing customers with the ATS’ rules of operation that would include definitions of order types, eligible participants and participant tiers, all forms of data feed products, order-routing logic and eligible-routing venues.
Ratterman believes that institutional investors would better served if their broker-dealers disclose to which ATS they route their clients’ orders and suggests ATS operators should voluntarily make their confidential Form ATS filings public. He also suggested a possible regulation that would require ATS operators to provide customers with their rules of operation, which would include order types, eligible participant and participant tiers, all forms of data feed product, order-routing logic and eligible routing venues.
“With this information, institutional investors might be better positioned to determine which trading venues best meet their trading needs, and compare disparate broker product and service offerings,” said Ratterman.
The sell side would also need to improve the transparency of its order-execution and order-routing mandated reports, under Regulation NMS Rule 605 and 606 respectively, since the industry adopted them 15 years ago and the technology supporting the market has changed considerably, he added.
Ratterman suggests amending Rule 605, which allows a trading venue to measure the quality of a particular execution by reference to any national best bid or offer in a one-second period, to reflect order executions taking place in milli- and micro-seconds.
“Given the frequency of quote updates in actively traded securities within any single second, compliance with this requirement may not in all cases provide adequate transparency into a particular venue’s true execution quality,” Ratterman explained. “Transparency could be improved by amending Rule 606 to require disclosure about routing of institutional orders, as well as a separate disclosure regarding the routing of marketable and non-marketable order, and the inclusion of execution quality data.”
From an exchange respective, Ratterman believes that neither reforms of the maker-taker exchange pricing mode, which provides a rebate to liquidity providers and charges a fee to remove liquidity from the market, or exchange order types is a wise idea
“Under Regulation NMS, exchange fees to access, ‘or take’, liquidity are capped at 30 cents per 100 shares, which effectively serves as a cap on the rebate that can be paid to liquidity markers,” he said. “Any attempt that would ban the current maker-taker fee model, limit payment for order flow generally or other attempts to alter the economics of trading
Ratterman viewed any attempts that would ban the current maker-taker fee model, limit payment for order flow generally or other a temps to alter the economic of trading price controls as blunt instrument, which likely would lead to disruptions and unforeseeable consequences for investors. “I am concerned that additional pricing restrictions could drive significantly more volume to dark venues or order types, make the compensation brokers receive for their liquidity far less transparent and widen the displayed bid-ask spread in a manner that effectively taxes all investors.”
Similarly, he suggested any potential review of SEC-approved exchange order types should be done carefully, since the current offerings originate from market demands of a diverse group of market participants,
Another driver in order-type creation is to address the excessive market complexity while meeting often overlooked regulations, such as Regulation NMS’ ban on locked markets, added Ratterman. “Given that existing regulatory guidance already effectively prohibits the locking of a market for the sole purpose of avoiding or reducing fees, revisiting regulatory obligations in this regard could be a simple yet powerful way to materially reduce the complexity of exchange operations.”