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Equity Perspectives

Occasionally, there is a hearing on Capitol Hill that deserves our attention.  This is one of them. 

At 9:30 a.m., Friday, February 28, 2014, the House Subcommittee on Capital Markets and Government Sponsored Enterprises met in Room 2128 of the Rayburn House Office Building to hold a hearing on the market impact of Securities Exchange Commission (SEC) Regulation National Market System (Reg. NMS).*

Attendance was sparse. Temperatures struggled to get out of the 20s, and another winter storm was threatening the nation’s capital over the weekend. But all four invited witnesses—including a former SEC commissioner, a former chief economist of the SEC, a former director of the SEC’s Division of Trading and Markets, and a partner in a leading financial regulatory law practice in Washington, D.C.—were there to testify in person. 

The purpose of the hearing was to examine the consequences, intended and otherwise, of Reg. NMS on market structure and investors. Enacted in 2005 and fully implemented two years later, Reg. NMS has been the subject of ongoing debate as to its effectiveness. Its aim was to foster both competition among individual markets and competition among individual orders in order to promote efficient and fair price formation across securities markets.  

Recently, the close association of Reg. NMS with high-speed, automated trading has brought the attention of a wider public audience to the claims of its critics, who claim Reg. NMS is a source of market complexity, dislocation, and disruption. Certainly, in the mindset of some of those testifying that day on Capitol Hill, the rule was an enabler of some fairly unsavory practices in the equity markets—practices that need to be confronted and remedied.

The hearing, however, did not address the specifics of Reg. NMS, which is a regulatory document comprising almost 400 pages; rather, it focused on issues of regulatory intent versus result, and it brought to the front of the debate some of the assumptions underlying government actions in financial markets. What follows is, in the words of those who testified, a perspective on the impact of Reg. NMS.

In Defense of Reg. NMS
It should be noted at the outset that only three of the five SEC commissioners in 2005 voted in favor of the rule. Roel C. Campos, one of the three, used the hearing to explain the rationale for the vote: 

“With Regulation NMS, we dealt with a decades-long trend in which market structure was evolving from manual trading to a market structure dominated by automated trading…. While the U.S. market share in trading is no longer concentrated in one market, our markets are linked as one national market system. The fact that executions can occur in any of over 60 platforms and exchanges does not mean that the markets are fragmented. After all, these platforms are linked and connected electronically—creating what Congress intended: a national market system where the best price can be found for investors in fractions of a second among all the trading centers. And assuring consistent inter-market trading rules was the right decision then, as it is now.”

Chester Spatt, chief economist at the SEC from 2004–07, and Campos’s peer at the time, concurred. “One of the more striking consequences of NMS was its emphasis in promoting electronic trading—the ‘fast markets,’” he testified. “Specialists could no longer retain a thirty-second option to evaluate competing alternatives through the old Intermarket Trading System. This helped open up the markets, in my view, and substantially contributed to the decline, from 50% to 20%, in the NYSE’s market share of its listed securities.”

Congressional Mandate
To fully understand the intent of the regulation, one needs to go back to 1975, when Congress passed the Securities Acts Amendments to the Securities Exchange Act of 1934, in particular Section 11A, directing the SEC to address a variety of issues regarding the structure of U.S. equity markets. 

“Section 11A was adopted to deal with the problems faced by the market at the time [1975],” according to testimony provided by Steven Lofchie, a partner at Cadwalader, Wickersham & Taft LLP. Those included “a monopoly on trading held by one exchange, slow manual executions, specialist profiteering based on knowledge of limit orders, spreads that were extremely high taking into account inflation and the dollar spread in today’s terms between a bid and offer, and limited access by non-NYSE members to the bids and offers available on the exchange floor.”

Section 11A mandated that the SEC facilitate the establishment of a national market system (NMS) consisting of multiple exchanges linked together by data processing and communications technologies. The primary objectives of this new NMS were to:

  • make executions of securities transactions more economically efficient;
  • promote fair competition among markets and securities firms;
  • improve the availability of market information to investors;
  • ensure that orders are executed in the best market; and
  • direct interaction among investor orders.

Over the next three decades, the SEC made a number of significant regulatory changes aimed at fulfilling its mandate under Section 11A of the Exchange Act. These changes included the Order Handling Rules in 1996, which removed a two-tier market structure that existed on NASDAQ; Regulation Alternative Trading Systems in 1998, which provided a framework for new electronic trading systems to develop outside of the framework of full exchange regulation; decimalization in 2000, which changed stock price increments from eighths to sixteenths, and finally to pennies; and Reg. NMS in 2005, which consolidated all rules promoting the national market system and attempted to address some of the problems that had arisen in equity market structure over the previous decade.

A Long-Overdue Review
According to Lofchie, Reg. NMS successfully addressed the problems of 1975, but created new ones. “Today’s problems are not those of a monopoly, they are of fragmentation; they are not of sloth, they are of speed; they are not of specialist profiteering, they are of the lack of strong incentives for firms to become market makers; they are not of over-reliance on the individuals who are specialists on the floor, they are of technology breakdowns; they are not of a private club of exchange members, they are of regulating competition between exchanges and their former members.”

Lofchie claimed the re-evaluation of Reg. NMS was long overdue. But he also warned: “If we go into the rewrite of the NMS rules thinking that we are just solving the same problems, we will exacerbate the very different problems that we now face.” 

And Campos did not disagree. “All major regulations need periodic review to assess suitability to the changing landscape,” he said. And “particular decisions in Reg. NMS…deserve a reevaluation…. The old adage ‘Do no harm’ comes to mind…. Some have suggested negative unintended consequences from Reg. NMS, which certainly require careful study and consideration by Congress and the SEC.”

“Trade-Throughs” and Exchange Competition
“‘A trade-through’ sounds like a bad thing, like a slight, a measure of disrespect. It is impossible to read the Reg. NMS Proposing Release and the NMS Adopting Release and not to be struck by the strength of the opprobrium to trade-throughs. It’s like hearing a Red Sox fan discuss the Yankees: they are simply bad, there is simply nothing good to be said about them.”
-- Steven Lofchie

Among the most controversial rulings of Reg. NMS is the Order Protection Rule, sometimes referred to as the “trade-through” rule. The intent of the rule is to ensure that all investors receive the best price (that is, the quote at the “top of the book”) when their order is executed. If the best price is offered on exchange A, then the trader must execute on that platform and not “trade through” to exchange B or C, where the price may be less favorable. Part of the controversy stems from the fact that the rule requires traders to select a trading platform based only on price rather than on issues of quality, such as the exchange offering the quickest execution or the most reliability.

“At its core, NMS is highly prescriptive,” Spatt testified, “which implies that aspects of its mandate can become entrenched and needlessly protect against potential market competition. To some extent, NMS imposes a degree of price-fixing and treats the pricing from different platforms equivalently and regards price outcomes as the product that various platforms provide. This limits the extent to which platforms can consider differentiating themselves and instead imposes a ‘one size fits all’ structure. Meanwhile, some platforms are performing SRO [self-regulatory oversight] services, while others are providing more modest compliance services. This raises the question as to whether price is all that matters from an investor’s perspective.”  

Lofchie asserted that it is a question of exchange competition and what serves investors best. “At some level,” Lofchie said, “the most fundamental decision that any securities regulator must make with respect to market structure is whether there should be one securities exchange, with the maximum possible depth and liquidity, or multiple exchanges competing with respect to the services that they provide market participants. There is something to be said for both structures, and the choice between them would be a very difficult one for the SEC to make—if there were, in fact, a choice. But there is not. The government and, in particular, the SEC, cannot and ought not order any ‘excess’ exchanges to discontinue their business. We are stuck with the benefits and the problems of having multiple exchanges.”

Lofchie continued. “Of course, once we have more than one exchange, there is no right number. So long as exchanges can satisfy the demands of market participants by providing an attractive place to trade, may they live long and prosper.”

“The difficulty with multiple exchanges arises when they survive, not necessarily because they provide a place for the competing bids and offers of market participants to meet and interact,” Lofchie said, “but because they provide a way to generate fees, directed by the government, that result from those bids and offers. This appears to be the case today: exchanges thrive…and multiply because the business of collecting and selling market data at SEC-regulated rates is thriving.” 

In fact, an entire industry has been created in which some high-frequency traders simply trade to collect rebate fees, adding no economic value to the process. One example of this is the so-called “make or take” trade.

Many electronic markets are organized as electronic limit order books. In this structure, there is no designated liquidity provider such as a specialist or a dealer. Presumably, liquidity arises endogenously from the submitted orders of traders. Traders who submit orders to buy or sell the asset at a particular price are said to “make” liquidity, while traders who choose to hit existing orders are said to “take” liquidity. 

According to Spatt, “important distortions in execution strategy and routing decisions arise from the ‘make or take’ pricing that is permitted under Reg. NMS. These distortions arise at various levels. For example, there are incentives to collect liquidity rebates and avoid fees for taking liquidity. At the same time, these fees and rebates are often booked to the broker rather than the customer, potentially significantly distorting the choice of venue in the routing decisions. Indeed, most routing decisions are not based on the effectiveness or timeliness of anticipated execution given equilibrium behavior.

“The regulatory structure sets the stage for conflicts of interest that would not arise intrinsically,” Spatt continued. “After all, in most commercial relationships it would be illegal for the purchasing agent to receive direct payments from the buyer.”

Lufchie believes that, “consequently, the exchanges are responding not so much to the demands of market participants [but] to the incentives built into the system by the regulators. So how do we let market participants demonstrate that they do not find real value in a given exchange? Fundamentally, it means that we have to let market participants elect not to trade on an exchange, even though it happens to display the best price. One way to let market participants demonstrate that they don’t find value in an exchange, the simplest way in fact, is that we let them “trade-through” that exchange…that is, we have to allow exchanges the possibility of failure.” 

“Dark Pools” and the Issue of Transparency
“We believe it is unfortunate that such a pejorative term [dark pool] has now become ingrained in the terminology used by the securities markets and policymakers to describe a type of trading venue that has brought certain benefits to all kinds of market participants, including funds and their shareholders.”
-- 
ICI Comment Letter with regard to the SEC’s Forced Transparency Release

“As we re-examine the NMS rules, rather than assuming that transparency is an unmitigated good, we should recognize it for what it is: the forced transfer of knowledge from someone who has valuable information to someone else who wants that valuable information.”
-- 
Steven Lofchie

Dark pools are private forums and exchanges for trading securities that are not openly available to the public.  They are used by institutional investors for buying and selling large blocks of securities without showing their hand to others and thus avoiding market impact. The existence of dark pools makes the market less transparent, critics claim. 

However, at the hearing on Capitol Hill, former SEC commissioner Campos defended the use of these alternative trading systems (ATS):

“I advise caution in assuming that trading systems known as ‘dark pools’ are per se a bad thing.  Remember that the competitive markets, not regulators, have determined that such platform systems provide valuable services…. Alternative trading systems and dark pools offer many benefits that [institutional] investors desire: the ability to trade large block orders without moving the market and offering, in many cases, price improvement. One particular ATS model regularly executes at the mid-point between bid and offer, providing substantial price improvement. Remember that institutional investors that use so called dark pools capture lower costs and price improvement for pensioners and beneficiaries, assisting in achieving retirement dreams.”

Within the context of asking regulators to better ground their decisions on the realities of how market participants actually operate, Sirri made the following point:

“Reg. NMS, coupled with ... advancements in communications …, and development of computer-driven strategies, have reshaped equity trading in the United States. But what haven’t changed are certain facts about market participants that affect trading and routing decisions. 

“Among these, I include the following: Traders avoid revealing their unexecuted trading interest to the market.  This observation is not a statement about the harmful use of dark pools or opaque order forms. Rather, traders have always valued confidentiality, a benefit historically conferred through use of the traditional exchange floor. Any rules to enhance transparency are constrained by this desire for confidentiality, as traders forced into a transparent market against their wishes will elect not to submit their orders in the first place, holding them ‘upstairs’ until they are ready. There is thus a limit to how much transparency can be brought to any marketplace.”

Lofchie asked that the regulatory assumption that transparency is always good—“so good that it must be forced upon the market to the greatest extent possible”—be scrutinized.

“If you are a long-term institutional investor who takes large positions based on in-depth fundamental corporate analysis,” Lofchie observed, “where would you send your quote: i) to be hung out in a naked bazaar exposed to the glare of high-frequency algorithmic momentum traders equipped with laser-speed co-located flickering quote transponders or ii) sheltered in a protective cove?”

Lofchie continued: “Transparency is not an unqualified good….Why not require mutual funds to broadcast their trading intent for the day in the morning, before the market even opens? …We don’t force mutual funds and the pension plans to be fully transparent because it would injure them…. But if it is obvious that we ought not to force [them] to reveal their intent in the hours before they trade, why is it obvious that we ought to force them to reveal their intent thirty minutes before they trade, or one minute, or five seconds, or one second? In fact, might it not instead follow that the mutual fund could be better served by sheltering its quote in a protective cove until the very instant of execution?”

Certainly, we have not heard the end of this discussion. Reg. NMS divided the SEC commissioners in 2005 and continues to be controversial. A number of lawsuits are in play based on the perceived injustices of its rules. We will keep you posted.

 

*All quotes and regulatory background sourced from individual testimony and documents at the Subcommittee on Capital Markets hearing, entitled “Equity Market Structure: A Review of SEC Regulation NMS.”  

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